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Welfare and Efficiency Consumer Surplus • Welfare Economics – How allocation of resources affect economic wellbeing • Willingness to pay – Maximum amount that a buyer is willing to spend on a good (remember margins) – height of demand curve at a quantity • Consumer Surplus – Willingness to pay minus amount paid • Think of the points on a demand curve as separate individuals • Each person only wants one cup of coffee • But each willing to pay a different maximum price • Construct a “market demand curve” • Start with a simplified “step demand curve” Market Demand For Coffee Four Individuals Maximum Willingness to Pay for Coffee Price Buyers Quantity Demanded John $1 >$1 None 0 Will $0.80 $0.80-$1 John 1 Sam $0.70 $0.70-$0.80 John, Will 2 $0.50-$0.70 Sam, John, Will 3 $0.50 & under Tim, Sam, John, Will 4 Tim $0.50 Step Demand Curve Price of Coffee $1 John’s Willingness to Pay Will’s Willingness to Pay $0.80 Sam’s Willingness to Pay $0.70 Tim’s Willingness to Pay $0.50 1 2 3 4 Quantity Demanded of Coffee • Demand Curve – Reflects People’s Willingness to Pay (height) – Helps measure consumer surplus • Consumer Surplus in a Market – Willingness to pay minus price paid – Graphically: Area between demand curve and price level Step Demand Curve Price of Coffee Johns Consumer Surplus = $0.20 $1 $0.80 $0.70 $0.50 1 2 3 4 Quantity Demanded of Coffee Step Demand Curve Price of Coffee John’s Consumer Surplus = $0.30 Will’s Consumer Surplus = $0.10 $1 $0.80 $0.70 $0.50 Total Consumer Surplus = $0.40 1 2 3 4 Quantity Demanded of Coffee • Buyers want to pay less, so lower price raises consumer surplus • At an initial P1, Q1 there is an initial surplus from first buyer • When price drops to P2 and quantity increases to Q2 – Buyer one pays lower price • His consumer surplus increases – New buyer enters market • They have a consumer surplus Initial Consumer Surplus Consumer Surplus P1 Consumer Surplus to new buyers P1 P2 Additional Consumer Surplus to Initial Buyers Q1 Q1 Q2 • Consumer Surplus – The benefit or gain buyers get from a transaction in the market – Measured from buyers point of view • Measure of Welfare – A good way to measure the economic well-being – Way to measure benefits from a market Producer Surplus • Way to think of Supply Curve – Supply Curve is willingness to accept – Lets say this is also their cost of production • Producer Surplus – Amount a seller receives for a good minus the cost of producing it – So the price level minus the height of the supply curve • Again lets start with a step supply curve where each seller sells one cup of coffee Supply Curve for Coffee $0.90 Alfred’s Cost of making a cup of coffee $0.70 Linda’s Cost of making a cup of coffee $0.50 Bob’s Cost of making a cup of coffee $0.40 Chris’s Cost of making a cup of coffee 1 2 3 4 • Supply Curve – Helps measure producer surplus – Viewed as willingness to accept (price they would take) – Viewed as cost of production • Producer Surplus – Difference between price received and cost of production – Area between price level and supply curve $0.90 $0.70 $0.50 $0.40 Chris’s Producer Surplus = $0.10 1 2 3 4 $0.90 Total Producer Surplus = $0.50 $0.70 $0.50 Bob’s Producer Surplus = $0.20 $0.40 Chris’s Producer Surplus = $0.30 1 2 3 4 • Sellers want to get more money, so a higher price raises producer surplus • At an initial P1, Q1 there is an initial surplus from first seller • When price increases to P2 and quantity increases to Q2 – Seller one gets higher price • His producer surplus increases – New seller enters market • They have a producer surplus Additional Producer Surplus to first seller Producer surplus from new seller P2 Producer Surplus P1 P1 Initial Producer Surplus from first seller Q1 Q1 Q2 Market Efficiency • Maximizing the surplus in a market – Getting the most out of the market • Total Surplus – Consumer surplus plus producer surplus – Value to consumers minus cost to producers • Efficiency vs Equality – Efficiency • Property of resource allocation • An economy wide property – Equality • A property of how economic prosperity is distributed • Depends on individuals How are Markets Efficient? • 1. Allocate the supply of goods to those who value them the most – Measured by willingness to pay – Height of demand curve (higher better) • 2. Allocate the demand for goods to producers who can make them at the lowest cost – Measured by willingness to accept – Height of supply curve (lower better) Consumer Surplus Producer Surplus Equilibrium and Efficiency • Cannot Increase economic well being by: – Changing who consumes the good (changing allocation among buyers) – Changing who produces the good (changing allocation of production among sellers) • Cannot Increase economic well being by: – Increasing or decreasing the quantity in the market – So • 3. The Free Market chooses the quantity of good that maximizes total surplus Buyers value good more than the cost of production so: Make More Buyers value good less than the cost of production so: Make Less Value to Buyers Cost to Producers Cost to Producers Value to Buyers Q* • So, Equilibrium is the Efficient allocation of resources • Market forces guide us to this point • Adam Smith’s ‘Invisible Hand’ • Laissez faire = allow them to do • Conclusion – Free market best way to organize economy – Keep Gov’t hands off • But, only IF The IF’s • Several Assumptions inherit in our conclusion • 1. Markets are perfectly competitive – No Market power • 2. Decisions of buyers and sellers only affect them and those in the market – No Externalities • When these are not true (market failure) our conclusion of unregulated market leading to best outcome may no longer be true