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Analysis of Competitive Markets In this section, we examine the social welfare implications of competitive markets. The approach taken here (and not the only one possible), is to use the devices of Producer and Consumer Surplus. The social welfare from the production and consumption of a particular amount of a good is assumed to be the sum of the producer and consumer surplus. Consumer & producer surplus slide 1 Optimality of competitive markets The principal claim is that social welfare (the sum of producer and consumer surplus) is maximized at the competitive price and quantity for a good. A series of examples are worked to show that a variety of policies and regulations, such as price fixing, taxes, and subsidies, will, in general, reduce social welfare from its maximum. Consumer & producer surplus slide 2 Key terms Willingness to pay: The maximum amount a buyer will pay for an amount of a good. Consumer surplus: A buyer's willingness to pay minus the amount actually paid. Cost: The value of everything a seller must give up to produce an amount of a good. Producer surplus: The amount the seller receives for the good minus the cost. Consumer & producer surplus slide 3 Consumer surplus can be measured using the demand curve for a product. P Demand for tacos P* D Q* Consumer & producer surplus Q slide 4 When Q* is sold, willingness to pay is the shaded area. P Demand for tacos P* D Q* Consumer & producer surplus Q slide 5 When Q* is sold at a price P*, consumers pay P* times Q*. Click to see the cost to consumers. Click again to see the shaded area that is consumer surplus. P Consumer surplus P* Demand for tacos Cost to consumers D Q* Consumer & producer surplus Q slide 6 Producer surplus can be measured using the supply curve for a product. S P Supply of tacos P' Q' Consumer & producer surplus Q slide 7 The shaded area is the cost of producing Q' of tacos. If the firm can sell at P', the total receipts are P' times Q'. P Supply of tacos Click to see the area that equals firms' revenues. P' Total revenue equals P' times Q'. Q' Consumer & producer surplus Q slide 8 Producer surplus is the shaded area. S P Supply of tacos P' Q' Consumer & producer surplus Q slide 9 P When QE is sold at a price of PE, consumer surplus is A, and producer surplus is B. S PE A B D QE Consumer & producer surplus Q slide 10 Notice on the previous slide that at the market equilibrium the sum of producer and consumer surplus (welfare) is maximized. Consumer & producer surplus slide 11 P Suppose Q' is sold at a price P' . What's the effect on welfare compared to the market? S P" P* D Q' Consumer & producer surplus Q* Q slide 12 P Consumer surplus is A . Producer surplus is B plus C. Compared to the market, there is a loss of D plus E. (Note that producers gain B, while consumers lose B.) S A P' B PE D E D C Q' Consumer & producer surplus QE Q slide 13 The next (hidden) slide shows the effects on welfare of producing less than the market amount. Hidden slide What if MORE than the market equilibrium quantity is produced? P S PE P' D QE Consumer & producer surplus Q' Q slide 16 What if MORE than the market equilibrium quantity is produced? P S A F E P' B D C Q' Consumer & producer surplus Q slide 17 When Q' is sold at P': CS is A + E PS is (B + C) - (C + E + F) = B - E - F Therefore: CS +PS is A + B - F This is less than CS + PS in the market (= A + B). Consumer & producer surplus slide 18 Conclusion If the demand curve (willingness to pay) is a good measure of the value of a good, and if the supply curve (the firm's cost) is a good measure of the cost to society to produce a good, then the best amount of the good to produce is where supply and demand are equal. Consumer & producer surplus slide 19