Download Mankiw:Chapter 7

Chapter 7
Consumers, Producers and
the Efficiency of Markets
Ratna K. Shrestha
Overview
Welfare Economics
 Consumer Surplus
 Producer Surplus
 Market Efficiency

Market Equilibrium Revisited
P
S
Does the equilibrium price
and quantity result in the
maximum total welfare of
buyer and seller?
PE
D
QE
Q
Market Equilibrium Revisited
 Market
equilibrium illustrates the way markets
allocate scarce resources. But does it answer
whether that market allocation is desirable?
 Welfare
Economics answers this question.
The question is whether this allocation
maximizes the combined welfare of both the
consumers and producers.
Welfare Economics…
 ….Is
the study of how the allocation of
resources affects economic well being, the
well being of the consumers and the sellers.
 Both buyers and sellers receive benefits from
taking part in the market.
 A consumer’s benefits is … the satisfaction
that he/she expects to receive from consuming
a good or service. A producer’s benefit is
usually its profits or surplus (defined later).
Marginal Benefit/Utility
is ……the amount of benefit (satisfaction)
that one more or one less unit of
consumption adds to or subtracts from total
benefits.
– A rational consumer tries to obtain the
largest possible total benefits (utility) from
the mix of goods and services they buy
with their incomes.
Consumer Surplus
 Consumers
buy goods because it makes
them better off (or provide utility). Consumer
Surplus measures how much better off they
are.
 Consumer Surplus
– from each unit: The amount a buyer is
willing to pay for a good minus the amount
the buyer actually pays for it.
Consumer Surplus - Example
 Assume
a student wants to buy concert tickets.
 Demand curve tells us the student’s willingness
to pay for each concert ticket
– 1st ticket worth $20 but price is $14 so
student generates $6 worth of surplus.
– We can measure this for each ticket.
– Total surplus is sum of surplus from each
ticket purchased.
Consumer Surplus - Example
Price
($ per
ticket)
The consumer surplus
of purchasing 6 concert
tickets is the sum of the
surplus derived from
each one individually.
20
19
18
17
16
15
Consumer Surplus
6 + 5 + 4 + 3 + 2 + 1 = 21
Market Price
14
13
0
Will not buy more than 7
because surplus from
additional ticket is negative
1
2
3
4
5
6
Rock Concert Tickets
Consumer Surplus
 The
stepladder demand curve can be converted
into a straight-line demand curve by making the
units of the good smaller.
 Consumer surplus measures the total net
benefit to consumers = total benefits from
consumption minus the total expenses.
 Thus, consumer surplus is area under the
demand curve and above the price.
 Note that the area under the demand curve up
to the level of consumption measures the total
benefits.
Consumer Surplus
Price
($ per
ticket)
20
Consumer
Surplus
14
Market Price
Demand Curve
Actual
Expenditure
0
1
2
3
4
5
6
Rock Concert Tickets
Consumer Surplus: Graphical
Pmax
S
Consumer
Surplus
PE
D
QE
P
$10
Total Consumer
Benefits
$9
$8
$7
$6
D
1
2
3
4
5
6
Q
P
$10
$9
$8
Consumer’s
Expense
$7
$6
D
1
2
3
4
5
6
Q
P
$10
Consumer Benefit
- Consumer Expense
CONSUMER SURPLUS!
$9
$8
$51 - $36 =
$15
$7
$6
D
1
2
3
4
5
6
Q
Consumer Surplus and Market Price
A lower market price will usually increase
consumer surplus.
 A higher market price will usually reduce
consumer surplus.


Consumer surplus will be smaller when the
demand curve is more elastic and larger
when the demand curve is inelastic.
How the Price Affects Consumer
Surplus?
Price
A
Consumer Surplus at
Price P2 vs. at Price P1
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
Copyright©2003 Southwestern/Thomson Learning
Producer Surplus
 Market
Supply depicts the various quantities
that suppliers would be willing to sell at different
prices.
 Supply curve can also be viewed as a measure
of the marginal (opportunity) cost to the seller of
supplying various quantities of the good.
 Assumption: The marginal (opportunity) cost of
production increases as market output
expands.
 Producer’s marginal cost of production is the
lowest price he/she would accept.
Producer Surplus: Verbal Definition
 Producer
Surplus is the amount a seller is
paid minus the cost of production.
 Producer surplus measures the benefit to
sellers of participating in a market.
– A producer might be willing to accept $3
(his/her MC of production) to supply the
good but in fact gets $5 market price.
– In this case, producer gains a surplus of $2.
PS = ($6 x 6) - ($1 +$2 + $3 + $4 + $5 + $6) = $15
P
S
$6
$5
$4
$3
$2
$1
1
2
3
4
5
6
Q
Total Producer
Benefits (Revenue)
P
S
$6
$5
$4
$3
$2
$1
1
2
3
4
5
6
Q
Producer Surplus =$15
P
S
$6
$5
$4
Producer
Costs
$3
$2
$1
1
2
3
4
5
6
Q
Producer Surplus: Graphical
S
P
PE
Producer
Surplus
D
QE
Q
How the Price Affects Producer
Surplus?
Producer Surplus at
Price P2 vs. at P1
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
Copyright©2003 Southwestern/Thomson Learning
Market Efficiency
The economic well-being of a society is
measured as the sum of consumer surplus
and producer surplus.
 Market Efficiency is attained when total
surplus is maximized, a point where resource
allocation is efficient.

Market Efficiency
Consumer
Surplus
S
PE
Producer
Surplus
D
Q
Market Efficiency:Three observations
 Free
markets allocate the supply of goods to
the buyers who value them most highly.
 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.
 However note that free market achieves
economic efficiency only under certain
conditions (but not all the times). When market
does not achieves efficiency, we call it market
failure.
Market Efficiency: Invisible Hand
 In
a free market system, many buyers and
sellers are interested in their own self-interest.
 As market participants are motivated by selfinterest a process of coordination and
communication takes place so that buyers
and sellers are directed to the most efficient
outcome.
 As if by an Invisible Hand, the free market
system reaches efficiency.
Efficiency of the Equilibrium Quantity
Supply
Price
Value
to
buyers
Cost
to
sellers
Cost
to
sellers
0
Value
to
buyers
Equilibrium
Quantity Q*
Value to buyers is greater
than cost to sellers.
If Q < Q*, value to
buyers > cost to
sellers. So efficiency
can be enhanced by
increasing Q.
Demand
Quantity
Value to buyers is less
than cost to sellers.
Copyright©2003 Southwestern/Thomson Learning
The Invisible Hand and e-Commerce
During the past few years, hundreds of Web
sites have been established that are dedicated to
facilitating trading in all types of goods, services,
and factors of production.
 These e-commerce innovations are increasing
consumer surplus, increasing producer surplus,
and achieving yet greater allocative efficiency.

Are Mega-Mergers Efficient?
Mergers enable firms to avoid duplication of
activities and bring resources into one
organization so that they can be used more
efficiently.
• But do mergers result in a more efficient
allocation of resources?
• Do they restrict output and produce less
than the efficient quantity?
• Do mergers need to be scrutinized by the
government and sometimes blocked?
Are Mega-Mergers Efficient?
Mergers are efficient if they cut costs or if
they bring marginal benefit closer to marginal
cost.
Mergers are inefficient if they raise costs or if
they widen the gap between marginal benefit
and marginal cost?
Does Ticket Scalping Enhance Efficiency?
If we want to allocate scarce resources
efficiently, it should get to the hands of those who
value them most.
Ticket Scalping helps to serve that purpose.
 Scalpers buy tickets to play, concerts, sports
events and sell the tickets at a price above the
original price and thus help to allocate the tickets
to those who value them most.
They may sometimes sell them even at lower
than original price (if they happen to have excess
tickets) to those who may not willing to pay
higher prices.

Ticket Scalping
Market Failure
 If
a market system is not competitive, control
over prices leads to Market Power.
– Market Power refers to the ability by one
buyer or seller to control market price.
– Monopoly. e.g., Microsoft, BC Hydro.
 Market Power causes markets to be inefficient,
and thus fail. For example, monopoly prices
are higher than competitive prices, and thus
negatively affects consumers.
 The monopolist gains but by less than what
consumers lose. Therefore monopoly reduces
total surplus.
Market Failure
 If
a consumption or production activity affects
individuals other than buyers and sellers of that
market, side-effects called externalities are
created.
– e.g., pollution from a factory adversely
affects people living nearby (third party).
– In a free market the polluter cares about its
profits only and so produces (and hence
pollutes) more than socially desirable.
– Thus free market with externality leads to
inefficiency.
Market Failure
 Assume
that smoking benefits the smoker by
$10 but harms nonsmokers by $100.
 In a free market, the smoker cares about only
himself and so will smoke.
 As a result the total surplus of the society
(smoker plus the nonsmokers) reduces by
$90.
 If there is no smoking (and hence externality),
this loss in surpluses can be avoided.
 How can the government avoid this loss?