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SUPPLY AND DEMAND II: MARKETS AND WELFARE
Consumers,
Producers, and the
Efficiency of Markets
Copyright © 2004 South-Western
7
REVISITING THE MARKET
EQUILIBRIUM
?
• Do the equilibrium price and
quantity maximize the total
welfare of buyers and sellers?
•/
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Welfare Economics
• Welfare economics is the study of how the
allocation of resources affects economic wellbeing.
1. Buyers and sellers receive benefits from taking
part in the market.
2. The equilibrium in a market maximizes the
total welfare of buyers and sellers.
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Welfare Economics
• Consumer surplus measures economic welfare
from the buyer’s side.
• Producer surplus measures economic
welfare from the seller’s side.
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CONSUMER SURPLUS
• Willingness to pay is the maximum
amount that a buyer will pay for a good.
• It measures how much the buyer values the
good or service.
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CONSUMER SURPLUS
1
• Calculation of Consumer surplus
• Consumer surplus is the buyer’s willingness to
pay for a good minus the amount the buyer
actually pays for it.
• Consumer surplus=
buyer’s willingness - amount the buyer
actually pays
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Table 1 Four Possible Buyers’ Willingness to Pay
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CONSUMER SURPLUS
• The market demand curve depicts the
various quantities that buyers would
be willing and able to purchase at
different prices.
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The Demand Schedule and the
Demand Curve
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Figure 1 The Demand Schedule and the Demand Curve
Price of
Album
John’s willingness to pay
$100
Paul’s willingness to pay
80
George’s willingness to pay
70
Ringo’s willingness to pay
50
Demand
0
1
2
3
4
Quantity of
Albums
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Figure 2 Measuring Consumer Surplus with the Demand
Curve
(a) Price = $80
Price of
Album
$100
John’s consumer surplus ($20)
80
70
50
Demand
0
1
2
3
4
Quantity of
Albums
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Figure 2 Measuring Consumer Surplus with the Demand
Curve
(b) Price = $70
Price of
Album
$100
John’s consumer surplus ($30)
80
Paul’s consumer
surplus ($10)
70
50
Total
consumer
surplus ($40)
Demand
0
1
2
3
4 Quantity of
Albums
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Using the Demand Curve to Measure
Consumer Surplus
• The area below the demand
curve and above the price
measures
the
consumer
surplus in the market.
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Figure 3 How the Price Affects Consumer Surplus
(a) Consumer Surplus at Price P
Price
A
The area below
the demand
curve and
above the price
measures the
consumer
surplus in the
market.
Consumer
surplus
P1
B
C
Demand
0
Q1
Quantity
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HOW A LOWER PRICE RAISES
CONSUMER SURPLUS
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Figure 3 How the Price Affects Consumer Surplus
(b) Consumer Surplus at Price P
Price
A
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
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What Does Consumer Surplus Measure?
2
• Consumer surplus, the amount that buyers
are willing to pay for a good minus the
amount they actually pay for it, measures the
benefit that buyers receive from a good as
the buyers themselves perceive it.
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PRODUCER SURPLUS
• Producer surplus is the amount a seller is paid
for a good minus the seller’s cost.
• It measures the benefit to sellers participating in
a market.
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Table 2 The Costs of Four Possible Sellers
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Using the Supply Curve to Measure Producer
Surplus
Just as consumer surplus is
related to the demand curve,
producer surplus is closely
related to the supply curve.
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The Supply Schedule and the
Supply Curve
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Figure 4 The Supply Schedule and the Supply Curve
Using the Supply Curve to Measure Producer
Surplus
• The area below the price and
above the supply curve measures
the producer surplus in a
market.
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USING THE SUPPLY CURVE TO
MEASURE
PRODUCER SURPLUS
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Figure 5 Measuring Producer Surplus with the Supply
Curve
(a) Price = $600
Price of
House
Painting
The area below
the price and
above
the
supply
curve
measures
the
producer
surplus in a
market.
Supply
$900
800
600
500
Grandma’s producer
surplus ($100)
0
1
2
3
4
Quantity of
Houses Painted
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Figure 5 Measuring Producer Surplus with the Supply
Curve
(b) Price = $800
Price of
House
Painting
$900
Supply
Total
producer
surplus ($500)
800
600
Georgia’s producer
surplus ($200)
500
Grandma’s producer
surplus ($300)
0
1
2
3
4
Quantity of
Houses Painted
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Figure 6 How the Price Affects Producer Surplus
(a) Producer Surplus at Price P
Price
Supply
P1
B
Producer
surplus
C
A
0
Q1
Quantity
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HOW A HIGHER PRICE RAISES
PRODUCER SURPLUS
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Figure 6 How the Price Affects Producer Surplus
(b) Producer Surplus at Price P
Price
Supply
Additional producer
surplus to initial
producers
P2
P1
D
E
F
B
Initial
producer
surplus
C
The area below
the price and
above
the
supply
curve
measures
the
producer
surplus in a
market.
Producer surplus
to new producers
A
0
Q1
Q2
Quantity
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MARKET EFFICIENCY
• Efficiency is the property of a
resource allocation of
maximizing the total surplus
received by all members of
society.
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MARKET EFFICIENCY
Consumer Surplus
= Value to buyers – Amount paid by buyers
and
Producer Surplus
= Amount received by sellers – Cost to sellers
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MARKET EFFICIENCY
Total surplus
= Consumer surplus + Producer surplus
or
Total surplus
= Value to buyers – Cost to sellers
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EVALUATING THE MARKET
EQUILIBRIU
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Is this equilibrium allocation of resources
efficient? Does it maximize total surplus?
To answer these questions, keep in mind that when a
market is in equilibrium, the price determines which buyers
and
sellers
participate
in
the
market.
-
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Figure 7 Consumer and Producer Surplus in the Market
Equilibrium
Price A
Consumer
surplus
Equilibrium
price
E
Producer
surplus
C
0
Equilibrium
quantity
Those buyers who value
the good more than the
price (represented by the
D
segment AE on the
Supply demand curve) choose to
buy the good; those
buyers who value it less
than the price
(represented by the
segment EB) do not.
Similarly, those sellers
whose costs are less than
the price (represented by
the segment CE on the
supply curve) choose to
produce and sell the
Demand good; those sellers whose
B
costs are greater than the
price (represented by the
segment ED)
Quantity
Copyright
© 2004 South-Western
Copyright©2003
Southwestern/Thomson Learning
MARKET EFFICIENCY
• Three points Concerning Market Outcomes,
• Free markets allocate
1.
the supply
of goods to the buyers who value
them most highly, as measured by their
willingness to pay.
2. The demand for goods to the sellers who can
produce them at least cost.
3. Free markets produce the quantity of goods that
maximizes the sum of consumer and producer
surplus. To see why this is true, consider
Copyright © 2004 South-Western
Figure 8 The Efficiency of the Equilibrium Quantity
Price
At quantities less than
the equilibrium
quantity, the value to
buyers exceeds the
cost to sellers.
At quantities greater
than the equilibrium
quantity, the cost to
sellers exceeds the
value to buyers.
Therefore, the
market
equilibrium
maximizes the sum
of producer and
0
consumer surplus.
Consumers,
Producers, and the
Efficiency of Markets
Supply
Value
to
buyers
Cost
to
sellers
Cost
to
sellers
Value
to
buyers
Equilibrium
quantity
Value to buyers is greater
than cost to sellers.
Demand
Quantity
Value to buyers is less
than cost to sellers.
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MARKET EFFICIENCY
• In addition to market efficiency, a
social planner might also care
about equity – the fairness of the
distribution of well-being among
the various buyers and sellers.
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We can now better appreciate Adam
Smith’s invisible hand of the marketplace,
The social planner doesn’t need to alter
the market outcome because the invisible
hand has already guided buyers and
sellers to an allocation of the economy’s
resources that maximizes total surplus.
This conclusion explains why economists
often
advocate
free
markets
as the best way to organize economic
activity.
Copyright © 2004 South-Western
Summary
• Consumer surplus equals buyers’ willingness to
pay for a good minus the amount they actually
pay for it.
• Consumer surplus measures the benefit buyers
get from participating in a market.
• Consumer surplus can be computed by finding
the area below the demand curve and above the
price.
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Summary
• Producer surplus equals the amount sellers
receive for their goods minus their costs of
production.
• Producer surplus measures the benefit sellers
get from participating in a market.
• Producer surplus can be computed by finding
the area below the price and above the supply
curve.
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Summary
• An allocation of resources that maximizes the
sum of consumer and producer surplus is said
to be efficient.
• Policymakers are often concerned with the
efficiency, as well as the equity, of economic
outcomes.
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Summary
• The equilibrium of demand and supply
maximizes the sum of consumer and producer
surplus.
• This is as if the invisible hand of the
marketplace leads buyers and sellers to allocate
resources efficiently.
• Markets do not allocate resources efficiently in
the presence of market failures.
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Assignment
• Draw the supply and demand for turkey. In the
equilibrium, show producer and consumer surplus. Explain why
producing more turkey would lower total surplus
• Explain how buyers’ willingness to pay, consumer
surplus, and the demand curve are related.
• Explain how sellers’ costs, producer surplus, and the
supply curve are related.
• In a supply-and-demand diagram, show producer and
consumer surplus in the market equilibrium
• What is efficiency? Is it the only goal of economic
policymakers?
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• There are four consumers willing to pay the following amounts
for haircuts:
• Jerry: $7 Oprah: $2
Sally Jessy: $8
Montel: $5
• There are four haircutting businesses with the following
• costs:
• Firm A: $3 Firm B: $6
Firm C: $4
Firm D: $2
• Each firm has the capacity to produce only one haircut.
•
•
•
•
For efficiency, how many haircuts should be given?
Which businesses should cut hair, and which consumers
should have their hair cut? How large is the maximum
possible total surplus?
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•
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•
•
•
•
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•
Ernie owns a water pump. Because pumping large
amounts of water is harder than pumping small
amounts, the cost of producing a bottle of water rises as
he pumps more. Here is the cost he incurs to produce
each bottle of water:
Cost of first bottle $1
Cost of second bottle 3
Cost of third bottle 5
Cost of fourth bottle 7
a. From this information, derive Ernie’s supply schedule. Graph his supply
curve for bottled water.
• b. If the price of a bottle of water is $4, how many bottles does Ernie
produce and sell? How much producer surplus does Ernie get from these
sales? Show Ernie’s producer surplus in your graph.
• c. If the price rises to $6, how does quantity supplied change? How does
Ernie’s producer surplus change? Show these changes in your graph
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