3 SUPPLY AND DEMAND II: MARKETS AND WELFARE

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3

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7

Consumers,

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REVISITING THE MARKET

EQUILIBRIUM

• Do the equilibrium price and quantity

maximize the total welfare of buyers and sellers?

• Market equilibrium reflects the way markets allocate scarce resources.

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Welfare Economics

• _{Welfare economics}_{is the study of how the}

allocation of resources affects economic

well-being.

• Buyers and sellers receive benefits from taking part in the market.

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Welfare Economics

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Welfare Economics

• Consumer surplus measures economic welfare from the buyer’s side.

• Producer surplus measures economic welfare

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CONSUMER SURPLUS

• _{Willingness to pay}_{is the maximum amount that} a buyer will pay for a good.

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CONSUMER SURPLUS

• _{Consumer surplus}_{is the buyer’s willingness to} pay for a good minus the amount the buyer

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Table 1 Four Possible Buyers’ Willingness to Pay

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CONSUMER SURPLUS

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Figure 1 The Demand Schedule and the Demand Curve

Price of Album

0 Quantity of

Albums

Demand

1 2 3 4

$100 John’s willingness to pay

80 Paul’s willingness to pay

70 George’s willingness to pay

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Figure 2 Measuring Consumer Surplus with the Demand Curve

(a) Price = $80 Price of

Album

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Figure 2 Measuring Consumer Surplus with the Demand Curve

(b) Price = $70 Price of

Album surplus ($40)

Quantity of Albums

John’s consumer surplus ($30)

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Using the Demand Curve to Measure Consumer Surplus

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Figure 3 How the Price Affects Consumer Surplus

Consumer surplus

Quantity (a) Consumer Surplus at Price P

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Figure 3 How the Price Affects Consumer Surplus

Initial consumer

surplus

Quantity (b) Consumer Surplus at Price P

Price

Consumer surplus to new consumers

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What Does Consumer Surplus Measure?

• _{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

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PRODUCER SURPLUS

• _{Producer surplus}_{is the amount a seller is paid}

for a good minus the seller’s cost.

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Table 2 The Costs of Four Possible Sellers

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Using the Supply Curve to Measure Producer Surplus

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Using the Supply Curve to Measure Producer Surplus

• The area below the price and above the supply curve measures the producer surplus in a

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Figure 5 Measuring Producer Surplus with the Supply Curve

Quantity of Houses Painted Price of

House

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Figure 5 Measuring Producer Surplus with the Supply Curve

Quantity of Houses Painted Price of

House

Georgia’s producer surplus ($200)

Total producer

surplus ($500)

Grandma’s producer surplus ($300)

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Figure 6 How the Price Affects Producer Surplus

surplus

Quantity (a) Producer Surplus at Price P

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Figure 6 How the Price Affects Producer Surplus

Quantity (b) Producer Surplus at Price P

Price

Producer surplus to new producers Additional producer

surplus to initial producers

D E

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MARKET EFFICIENCY

• Consumer surplus and producer surplus may be used to address the following question:

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MARKET EFFICIENCY

Consumer Surplus

= Value to buyers – Amount paid by buyers

and

Producer Surplus

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MARKET EFFICIENCY

Total surplus

= Consumer surplus + Producer surplus

or

Total surplus

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MARKET EFFICIENCY

• _Efficiency_{is the property of a resource}

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MARKET EFFICIENCY

• In addition to market efficiency, a social

planner might also care about equity – the

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Figure 7 Consumer and Producer Surplus in the Market Equilibrium

Producer surplus Consumer

surplus

Price

0 Quantity

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MARKET EFFICIENCY

• Three Insights Concerning Market Outcomes

• Free markets allocate the supply of goods to the

buyers who value them most highly, as measured by their willingness to pay.

• Free markets allocate the demand for goods to the sellers who can produce them at least cost.

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Figure 8 The Efficiency of the Equilibrium Quantity

than cost to sellers.

Value to buyers is less than cost to sellers. Equilibrium

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Evaluating the Market Equilibrium

• Because the equilibrium outcome is an efficient allocation of resources, the social planner can leave the market outcome as he/she finds it. • This policy of leaving well enough alone goes

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• Market Power

• If a market system is not perfectly competitive,

market power may result.

• Market power is the ability to influence prices. • Market power can cause markets to be inefficient

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• Externalities

• created when a market outcome affects individuals other than buyers and sellers in that market.

• cause welfare in a market to depend on more than just the value to the buyers and cost to the sellers.

• When buyers and sellers do not take

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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.

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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.

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Summary

• An allocation of resources that maximizes the sum of consumer and producer surplus is said to be efficient.

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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.