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A Lecture Presentation
to accompany
Exploring Economics
3rd Edition
by Robert L. Sexton
Copyright © 2005 Thomson Learning, Inc.
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Printed in the United States of America
ISBN 0-324-26086-5
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Chapter 7
Market Efficiency
and
Welfare
Copyright © 2002 by Thomson Learning, Inc.
7.1 Consumer Surplus and
Producer Surplus
 Using the tools of consumer and
producer surplus, we can
demonstrate the efficiency of a
competitive market.
 We can also use the tools of
consumer and producer surplus to
study the welfare effects of
government policy—rent controls,
taxes, and agricultural support prices.
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
Welfare to economists does not mean
a government payment to the poor;
rather, it is a way we measure the
impact of a policy on a particular
group—like consumers or producers.
Copyright © 2002 by Thomson Learning, Inc.
Consumer Surplus


What a consumer actually pays for a
good is usually less than what she is
willing to pay.
The monetary difference between
what the consumer is willing and able
to pay and the price the consumer
actually pays is called consumer
surplus.
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Marginal Willingness to Pay
Falls as More is Consumed

If the consumer is a buyer of several
units of a good, the earlier units will
have greater marginal value and
therefore create more consumer
surplus because marginal willingness
to pay falls as greater quantities are
consumed in any period.
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Copyright © 2002 by Thomson Learning, Inc.

Consumer surplus is shown
graphically as the area under the
demand curve (willingness to pay
for the units consumed) and above
the market price (what must be paid
for those units).
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Copyright © 2002 by Thomson Learning, Inc.
Price Changes and Changes in
Consumer Surplus


Exhibit 3 shows the gain the
consumer surplus associated with
say a technological advance that
shifts the supply curve to the right.
As a result, equilibrium price falls
and quantity rises.
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Copyright © 2002 by Thomson Learning, Inc.
Producer Surplus


Producer surplus is the difference
between what a producer is paid for
a good and the seller's cost for
producing each unit of the good.
Because some units can be produced
at a cost that is lower than the
market price, the seller receives a
surplus, or net benefit, from
producing those units.
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

Producer surplus for a particular unit is
the difference between the market price
and the seller's cost of producing that
unit.
Total producer surplus is shown
graphically as the area under the market
price (what was paid for those units) and
above the supply curve (the total cost, or
sum of marginal costs, of producing those
units).
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Copyright © 2002 by Thomson Learning, Inc.



A higher market price due to an
increase in demand will increase total
producer surplus.
Part of the added surplus is due to a
higher price for the quantity already
being produced.
Part is due to the expansion of output
made profitable by the higher price.
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Copyright © 2002 by Thomson Learning, Inc.
Market Efficiency and Producer
and Consumer Surplus


With the tools of consumer and
producer surplus, we can better
analyze the total gains from
exchange.
The demand curve represents a
collection of maximum prices that
consumers are willing and able to
pay for additional quantities of a
good or service.
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


The supply curve represents a collection
of minimum prices that suppliers require
to be willing to supply additional
quantities of that good or service.
At the market equilibrium, consumers
receive consumer surplus and producers
receive producer surplus.
Both benefit from trading every unit up
to the market equilibrium output.
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

Buyers purchase each good, except
for the very last unit, for less than
the maximum amount that they
would have been willing to pay.
Sellers receive more than the
minimum amount they would have
been willing to accept to supply the
good.
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

Once the equilibrium output is
reached at the equilibrium price, all
of the mutually beneficial trade
opportunities between the suppliers
and the demanders will have taken
place.
The sum of consumer and producer
surplus is maximized.
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

The total welfare gains to the
economy from trade in a good is the
sum of the consumer and producer
surplus created.
Consumers benefit from additional
amounts of consumer surplus and
producers benefit from additional
amounts of producer surplus.
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

Improvements in welfare come from
additions to both consumer and
producer surplus.
In competitive markets, where there
are large numbers of buyers and
sellers at the market equilibrium price
and quantity, the net gains to society
are as large as possible.
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Copyright © 2002 by Thomson Learning, Inc.


Not producing the efficient level of
output, in this case 4 million units,
leads to what economists call a
deadweight loss.
A deadweight loss will often result
in a reduction of both consumer and
producer surpluses—it is the net loss
of total surplus that results from the
misallocation of resources.
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7.2
The Welfare Effects of Taxes,
Subsidies, and Price Controls


We can use consumer and producer
surplus to measure the welfare
effects of various government
programs—taxes and price controls.
When economists use the term
welfare effects of a government
policy, they are referring to the gains
and losses associated with
government intervention.
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Using Consumer and Producer Surplus to
Find the Welfare Effects of a Tax

The tax is illustrated by the vertical
distance between the supply and
demand curve at the new after-tax
output—shown as the bold vertical
line in Exhibit 1.
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Copyright © 2002 by Thomson Learning, Inc.
Quantity

In Exhibit 2, we can now use
consumer and producer surplus to
measure the amount of welfare loss
associated with a tax.
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Copyright © 2002 by Thomson Learning, Inc.
Elasticity and the Size of the
Deadweight Loss


The size of the deadweight loss from
a tax, as well as how the burdens are
shared between buyers and sellers,
depends on the price elasticities of
supply and demand.
That is, the more elastic the curves
are, the greater the change in output
and the larger the deadweight loss.
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Copyright © 2002 by Thomson Learning, Inc.
Quantity




Elasticity differences can help us
understand tax policy.
Those goods that are heavily taxed often
have a relatively inelastic demand curve in
the short run.
This means that the burden falls mainly on
the buyer.
It also means that the deadweight loss to
society is smaller than if the demand curve
was more elastic.
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The Welfare Effects of
Subsidies



If taxes cause deadweight or welfare
losses, do subsidies create welfare
gains?
Think of a subsidy as a negative tax.
In Exhibit 4, we see that the subsidy
lowers the price to the buyer and
increases the quantity exchanged.
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

Producers lose producer surplus from
the lower imposed ceiling price.
The net loss is the resulting
deadweight loss triangle, just as with
a tax.
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Copyright © 2002 by Thomson Learning, Inc.
Price Ceilings and Welfare
Effects


We can see the welfare effects of a
price ceiling by observing the change
in consumer and producer surplus
from the implementation of the price
ceiling.
Consumers can now buy at a lower
price, but cannot buy as much as
before (since suppliers will not supply
as much).
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Price Floors


We can also use consumer and producer
surplus to see the welfare effects of a price
floor, where the government buys up the
surplus.
Consumers lose consumer surplus due to
the higher price floor, and must also pay
taxes to pay for the buying and storing of
the unsold (to consumers) output.
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

Producers gain producer surplus from
the higher prices and greater output
(since the government buys up what
is not sold on the market).
On net, there is a deadweight loss
from the price floor, illustrated in
Exhibit 6.
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Copyright © 2002 by Thomson Learning, Inc.
Quantity of Cheese
Welfare Effects of a Price Floor When
the Government Buys the Surplus


Who gains and who loses under price
support programs when the
government buys the surplus?
In Exhibit 7, the equilibrium price
and quantity without the price floor
are at P1 and Q1, respectively.
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Copyright © 2002 by Thomson Learning, Inc.

In Exhibit 8, if the government sets
the target price at P2, producers will
supply Q2 and sell all they can at the
market price, PM.
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.