Download 4_CS PS Efficiency

Consumer Surplus, Producer Surplus,
and Market Efficiency
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Welfare Economics
• Welfare economics: the study of how the allocation of resources affects
economic well-being
• Transition from positive analysis to normative analysis
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Consumer Surplus
• Consumer surplus (CS): the area below the demand curve and above the
price line
• CS = Total WTP – total expenditure
• A measure of consumer(s) well-being
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Producer Surplus
• Producer surplus (PS): the area above the supply curve and below the
price line
• PS = Total revenue (TR) – variable costs (VC)
• A measure of producer(s) well-being
• Relationship between profit and PS?
– Profit = TR – TC = TR – (FC + VC)
– Not the same if FC > 0
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Efficiency
• Total surplus: TS = CS + PS
• Measure of consumer(s) and producer(s) well-being
• Efficiency: the property of a resource allocation of maximizing the TS
received by all members of society
• Efficiency is the normative criteria of economics
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Perfectly Competitive Markets are Efficient
• The equilibrium price and quantity (P*,Q*) maximize total surplus
• Proof by contradiction
– If Q < Q*, there is a deadweight loss (DWL) and TS is lower
– If Q > Q*, there is a DWL and TS is lower
– Must be true that Q* and therefore P* maximize TS
• This is Adam Smith’s “Invisible Hand” at work
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Concepts Relating Efficiency and Equity
• Pareto efficiency: a situation where no one can be made better-off without
making someone else worse-off
• Pareto improvement: a change that makes at least one individual betteroff without making anyone else worse-off
• Potential Pareto improvement: a change that makes some people betteroff by enough that they could compensate any losers so that no one is
made worse-off
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