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3
SUPPLY AND DEMAND II: MARKETS AND WELFARE
Consumers,
Producers, and the
Efficiency of Markets
Copyright © 2004 South-Western
7
REVISITING THE MARKET
EQUILIBRIUM
• Do the equilibrium price and quantity maximize
the total welfare of buyers and sellers?
• Market equilibrium reflects the way markets
allocate scarce resources.
• Whether the market allocation is desirable can
be addressed by welfare economics.
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Welfare Economics
• Welfare economics is the study of how the
allocation of resources affects economic wellbeing.
• Buyers and sellers receive benefits from taking
part in the market.
• The equilibrium in a market maximizes the total
welfare of buyers and sellers.
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Welfare Economics
• Equilibrium in the market results in maximum
benefits, and therefore maximum total welfare
for both the consumers and the producers of the
product.
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Welfare Economics
• Consumer surplus measures economic welfare
from the buyer’s side.
• Producer surplus measures economic welfare
from the seller’s side.
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CONSUMER SURPLUS
• Willingness to pay is the maximum amount that
a buyer will pay for a good.
• It measures how much the buyer values the
good or service.
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CONSUMER SURPLUS
• Consumer surplus is the buyer’s willingness to
pay for a good minus the amount the buyer
actually pays for it.
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Table 1 Four Possible Buyers’ Willingness to Pay
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CONSUMER SURPLUS
• The market demand curve depicts the various
quantities that buyers would be willing and able
to purchase at different prices.
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The Demand Schedule and the
Demand Curve
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Figure 1 The Demand Schedule and the Demand Curve
Price of
Album
John’s willingness to pay
$100
Paul’s willingness to pay
80
George’s willingness to pay
70
Ringo’s willingness to pay
50
Demand
0
1
2
3
4
Quantity of
Albums
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Figure 2 Measuring Consumer Surplus with the Demand
Curve
(a) Price = $80
Price of
Album
$100
John’s consumer surplus ($20)
80
70
50
Demand
0
1
2
3
4
Quantity of
Albums
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Figure 2 Measuring Consumer Surplus with the Demand
Curve
(b) Price = $70
Price of
Album
$100
John’s consumer surplus ($30)
80
Paul’s consumer
surplus ($10)
70
50
Total
consumer
surplus ($40)
Demand
0
1
2
3
4 Quantity of
Albums
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Using the Demand Curve to Measure
Consumer Surplus
• The area below the demand curve and above
the price measures the consumer surplus in the
market.
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Figure 3 How the Price Affects Consumer Surplus
(a) Consumer Surplus at Price P
Price
A
Consumer
surplus
P1
B
C
Demand
0
Q1
Quantity
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Figure 3 How the Price Affects Consumer Surplus
(b) Consumer Surplus at Price P
Price
A
Initial
consumer
surplus
P1
P2
0
C
B
Consumer surplus
to new consumers
F
D
E
Additional consumer
surplus to initial
consumers
Q1
Demand
Q2
Quantity
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What Does Consumer Surplus Measure?
• Consumer surplus, the amount that buyers are
willing to pay for a good minus the amount they
actually pay for it, measures the benefit that
buyers receive from a good as the buyers
themselves perceive it.
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Midterm Is Thursday, March 2
• Two examples of past midterms are on the
website.
• The midterm will follow that general pattern.
• The makeup exam will be offered in class time,
Thursday, March 9.
• You must provide an official authorized excuse
to have a make-up exam administered.
• If you are eligible, please arrange taking the
makeup first with your TA.
Copyright © 2004 South-Western
A Sample Test Answer: Q3 from
2002 Midterm
•
•
•
•
•
Throughout this question, you should assume that (i) demand is neither
perfectly elastic nor perfectly inelastic and (ii) supply is neither perfectly
elastic nor perfectly inelastic.
A) Draw the demand and supply curve for hot dogs. Show the equilibrium
price and quantity.
B) What will happen to the equilibrium price and quantity of hot dogs if a
new study finds that eating hot dogs increases the chances you will have a
heart attack? Present and discuss a supply and demand diagram as part of
your answer.
C) Suppose that, AT THE SAME TIME (i) a new study finds that eating
hot dogs increases the chances you will have a heart attack AND (ii) firms
find a new way to produce hot dogs at a lower cost. What will happen to
the equilibrium price and quantity of hot dogs? Present and discuss a
SINGLE supply and demand diagram as part of your answer.
D) As in C) Suppose that, AT THE SAME TIME (i) a new study finds
that eating hot dogs increases the chances you will have a heart attack
AND (ii) firms find a new way to produce hot dogs at a lower cost. What
will happen to the equilibrium price and quantity of HAMBURGERS?
Present and discuss a SINGLE supply and demand diagram as part of
your answer.
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A Strategy for Answering.
• Read ALL the question first.
• Determine any information that may be relevant
(eg. Not perfectly inelastic S or D, H and HD
are complements.)
• For each question develop a strategy for
answering using the three step method
suggested by Mankiw.
• Try to resist the temptation to say TOO much.
False statements will cause a point deduction.
• Then start...
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Part A)
Price
S
PE
D
QE
Quantity
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Part B)
• The news causes the demand curve to shift in.
• The new equilibrium price and quantity are both lower.
S
Price
PE
P’
D
Q’ QE
Quantity
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Part C)
• The part ii) news causes the supply curve to shift out.
• The new equilibrium price is both lower than P and P’.
• The new equilibrium quantity is higher than Q’ but may be
S
higher or lower than Q
Price
PE
P’
P’’
D
Q’ Q’’
Quantity
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Part D)
• Start with the original D and S curve for Hamburgers.
• How does the health news affect D and S in the Hamburger
market? i) Presumably it increases H demand.
• This raises H price and quantity.
Price
S
D
QHamburger
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Part D)
• Since Hamburgers and Hot Dogs are substitutes, though, the
technology driven fall in price in HD (ii) should cause a second,
leftward shift in demand for Hamburgers. How far the shift is
cannot be determined from the information.
• Therefore, the final price and quantity may be higher or lower.
S
Price
D
QHamburger
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PRODUCER SURPLUS
• Producer surplus is the amount a seller is paid
for a good minus the seller’s cost.
• It measures the benefit to sellers participating in
a market.
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Table 2 The Costs of Four Possible Sellers
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Using the Supply Curve to Measure Producer
Surplus
• Just as consumer surplus is related to the
demand curve, producer surplus is closely
related to the supply curve.
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The Supply Schedule and the
Supply Curve
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Figure 4 The Supply Schedule and the Supply Curve
Using the Supply Curve to Measure Producer
Surplus
• The area below the price and above the supply
curve measures the producer surplus in a
market.
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Figure 5 Measuring Producer Surplus with the Supply
Curve
(a) Price = $600
Price of
House
Painting
Supply
$900
800
600
500
Grandma’s producer
surplus ($100)
0
1
2
3
4
Quantity of
Houses Painted
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Figure 5 Measuring Producer Surplus with the Supply
Curve
(b) Price = $800
Price of
House
Painting
$900
Supply
Total
producer
surplus ($500)
800
600
Georgia’s producer
surplus ($200)
500
Grandma’s producer
surplus ($300)
0
1
2
3
4
Quantity of
Houses Painted
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Figure 6 How the Price Affects Producer Surplus
(a) Producer Surplus at Price P
Price
Supply
P1
B
Producer
surplus
C
A
0
Q1
Quantity
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Figure 6 How the Price Affects Producer Surplus
(b) Producer Surplus at Price P
Price
Supply
Additional producer
surplus to initial
producers
P2
P1
D
E
F
B
Initial
producer
surplus
C
Producer surplus
to new producers
A
0
Q1
Q2
Quantity
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MARKET EFFICIENCY
• Consumer surplus and producer surplus may be
used to address the following question:
• Is the allocation of resources determined by free
markets in any way desirable?
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MARKET EFFICIENCY
Consumer Surplus
= Value to buyers – Amount paid by buyers
and
Producer Surplus
= Amount received by sellers – Cost to sellers
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MARKET EFFICIENCY
Total surplus
= Consumer surplus + Producer surplus
or
Total surplus
= Value to buyers – Cost to sellers
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MARKET EFFICIENCY
• Efficiency is the property of a resource
allocation of maximizing the total surplus
received by all members of society.
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MARKET EFFICIENCY
• In addition to market efficiency, a social
planner might also care about equity – the
fairness of the distribution of well-being among
the various buyers and sellers.
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Figure 7 Consumer and Producer Surplus in the Market
Equilibrium
Price A
D
Supply
Consumer
surplus
Equilibrium
price
E
Producer
surplus
B
Demand
C
0
Equilibrium
quantity
Quantity
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MARKET EFFICIENCY
• Three Insights Concerning Market Outcomes
• Free markets allocate the supply of goods to the
buyers who value them most highly, as measured by
their willingness to pay.
• Free markets allocate the demand for goods to the
sellers who can produce them at least cost.
• Free markets produce the quantity of goods that
maximizes the sum of consumer and producer
surplus.
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Figure 8 The Efficiency of the Equilibrium Quantity
Price
Supply
Value
to
buyers
Cost
to
sellers
Cost
to
sellers
0
Value
to
buyers
Equilibrium
quantity
Value to buyers is greater
than cost to sellers.
Demand
Quantity
Value to buyers is less
than cost to sellers.
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Evaluating the Market Equilibrium
• Because the equilibrium outcome is an efficient
allocation of resources, the social planner can
leave the market outcome as he/she finds it.
• This policy of leaving well enough alone goes
by the French expression laissez faire.
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Evaluating the Market Equilibrium
• Market Power
• If a market system is not perfectly competitive,
market power may result.
• Market power is the ability to influence prices.
• Market power can cause markets to be inefficient because
it keeps price and quantity from the equilibrium of supply
and demand.
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Evaluating the Market Equilibrium
• Externalities
• created when a market outcome affects individuals
other than buyers and sellers in that market.
• cause welfare in a market to depend on more than
just the value to the buyers and cost to the sellers.
• When buyers and sellers do not take
externalities into account when deciding how
much to consume and produce, the equilibrium
in the market can be inefficient.
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Summary
• Consumer surplus equals buyers’ willingness to
pay for a good minus the amount they actually
pay for it.
• Consumer surplus measures the benefit buyers
get from participating in a market.
• Consumer surplus can be computed by finding
the area below the demand curve and above the
price.
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Summary
• Producer surplus equals the amount sellers
receive for their goods minus their costs of
production.
• Producer surplus measures the benefit sellers
get from participating in a market.
• Producer surplus can be computed by finding
the area below the price and above the supply
curve.
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Summary
• An allocation of resources that maximizes the
sum of consumer and producer surplus is said
to be efficient.
• Policymakers are often concerned with the
efficiency, as well as the equity, of economic
outcomes.
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Summary
• The equilibrium of demand and supply
maximizes the sum of consumer and producer
surplus.
• This is as if the invisible hand of the
marketplace leads buyers and sellers to allocate
resources efficiently.
• Markets do not allocate resources efficiently in
the presence of market failures.
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