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Welfare Analysis
• Consumers buy and producer sells. Both
benefit from the trade.
• You do a hair cut for $80. Your gross benefit in
term of money should be larger or at least
equal to $80. What is you benefit net of the
cost?
• I offer the haircut to you for $80. It costs me
$80 or less. What is my benefit net of the cost?
Welfare Analysis
•
•
•
Concepts of these gain (or loss):
Consumer surplus: consumer’s net benefit from transactions.
Producer surplus: producer’s net benefit from transactions.
In economics, these are called welfare analysis.
Why welfare analysis? Only after we know the net benefit of
some market situations can we decide: Do we need to
implement some policies to change the current situation? Is the
current institutional arrangement ideal?
• Reading: 4.4
Consumer Surplus
• The simplest way to evaluate consumers’ benefit from
market exchange is to use demand curve.
• The idea: People’s valuation of a good is different.
The keenest person is willing to pay more. The least
enthusiastic person is willing is pay less. However, in
most situations (in a competitive market), price
charged for the good is the same for all different
people. → Those who voluntarily buy is expected to
gain from the purchase.
Demand
• Back to the small town, the 4 long hairs’
maximum money that they are willing to pay
for a haircut are:
- Amy: $120
- Benny: $80
- Calvin: $50
- Dora: $30
Demand
• If market price is $50, Amy,
Benny, Calvin will do the deal.
• The value of the haircut to
Amy is $120. She indeed has a
net gain of $70.
• Benny’s net gain: $30.
• Calvin’s net gain: $0.
• Total net gain: $100 =
consumer surplus
Amy: $120
Benny: $80
Calvin: $50
Dora: $30
Consumer Surplus
• Consumer surplus:
- Adding up the blue
charts.
- Adding up the consumer
value above the market
price.
- The part of demand
charts (curve) that is
above market price.
Price of a Haircut
120
70
30
80
50
30
1
2
3
4
Quantity Demanded of Haircut
(Unit: No. of Consumers on Saturday)
• Another example: Each one may not buy just one
unit of a good. Apple. Amy and Benny.
• If market price is $4, Amy’s net gain is $6 (buy one
apple). Benny’s net gain is $6+$1 (buy 2 apples).
Price of Apple
Price of Apple
10
Price of Apple
10
Amy
10
Benny
Market Demand
5
5
5
2
2
2
1
2
Quantity Demanded of Apple
1
2
3
Quantity Demanded of Apple
1
2
3
4
5
Quantity Demanded of Apple
Consumer Surplus
Price
2000
A
1000
• If the good is highly
divisible (not haircut),
we have a demand
curve, not charts.
• Consumer surplus is
the triangle area
above price.
Quantity
0
5
10
Producer Surplus
• Producer surplus: In a competitive market,
homogeneous products are sold at one price.
• But producers produces products at different
costs. Even though price is as low as $2, I may
be willing to sell. But you won’t, you require
at least $3.
• If I can sell it at $3, I won’t sell it at $2, even
though I will if I can only sell it at $2.
• My surplus is $1 if price is $3.
Supply
•
•
•
•
•
•
Again, in our small town, four barbers.
Kim Robertson requires at least $160 for a haircut.
Mr Chan requires at least $110 for a haircut.
X-man requires at least $80.
Regina requires at least $60.
Note that the lowest price required should reflect the
barber’s cost of providing the service. The X-man
doesn’t want to do the job because doing some other
thing (e.g. sleeping) should give him a value of $80.
• The value of the next best alternative to X-man is $80.
The opportunity cost of the haircut job is $80.
Supply
• Suppose the market price is
$100.
• Only X-man and Regina do.
• X-man’s net gain is $20.
• Regina’s net gain is $40.
• Total net gain is $60 =
producer surplus.
Kim: $160
Mr Chan: $110
X-man: $80
Regina: $60
Producer Surplus
• Producer surplus:
- Adding up the yellow
charts
- Adding up the value in
excess of cost by
suppliers
- The area between price
and supply charts.
Price of Haircut
160
120
110
80
60
50
30
1
2
3
4
Quantity Demanded of Haircut
(Unit: No. of Consumers on Saturday)
Producer Surplus
Price
($ per unit)
S
Quantity
•Similarly, if
quantity is highly
divisible, we’ll
get a smooth
supply curve.
•Producer surplus
is the triangle
below the price
and above the
supply curve.
Welfare in Market Equilibrium
• Surely, price is not
arbitrarily determined.
In equilibrium, there is
only one price
sustaining.
• Equilibrium price is $80.
• Consumer surplus: $40.
• Producer surplus: $20.
• Total surplus: $60.
Price of Haircut
160
120
110
80
60
50
30
1
2
3
4
Quantity Demanded of Haircut
(Unit: No. of Consumers on Saturday)
Welfare in Market Equilibrium
S
Price
($ per unit)
• Total welfare in
this market
situation is?
• Why P0Q0 is not
the welfare?
P0
D
Q0
Quantity