3

SUPPLY AND DEMAND II: MARKETS AND WELFARE

7
Consumers, Producers, and the Efficiency of Markets

Revisiting The Market Equilibrium

The theory of supply and demand shows how markets allocate scarce resources among competing needs. But are the equilibrium price and quantity the right price and the right quantity from societys point of view? Do they maximize the total welfare of buyers and sellers? Whether the market allocation is desirable or not is the topic of welfare economics.
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Welfare Economics
Welfare economics is the study of how the allocation of resources affects economic well-being It shows that:
Both buyers and sellers receive benefits from taking part in the market The equilibrium outcomethat we saw in Chapter 4maximizes the total welfare of buyers and sellers
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Welfare Economics: two main concepts

Consumer surplus measures economic welfare of the buyer. Producer surplus measures economic welfare of the seller.

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Willingness to pay
To define consumer surplus we first need to define willingness to pay. Willingness to pay is the maximum amount that a buyer will pay for a good. It measures how much the buyer values the good.

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Willingness to pay
Assume there is a commodity such that every additional unit of it increases a consumers happiness by the same amount
In other words, the consumption of additional units of this commodity induces neither boredom nor addiction Possible examples: potato chips? candy?

Then the consumers willingness to pay for a product is an accurate measure of the happiness that he or she gets from it
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 7

Willingness to pay
continuation from previous slide If a bag of potato chips provides an unchanging amount of happiness, and if your willingness to pay is
4 bags of potato chips for a shirt and 2 bags for a cup of coffee, then one can safely say that the shirt makes you twice as happy as the cup of coffee In other words, your willingness to pay for a commodity is an accurate measure of how much you like that thing

For a given dollar price of a bag of potato chips, your willingness to pay can also be expressed in dollars
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Willingness to pay
continuation from previous slide For example,
if you are willing to pay $15 for a particular shirt, and if a bag of potato chips always gives you 3 haps of happiness, and sells at the price of $0.50 each, then the shirt gives you 90 haps of happiness.

In other words, your willingness to pay for the shirt is

a monetary measure of the happiness you get from the shirt, which is proportional to the happiness you get from the shirt, as measured in haps
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 9

Table 1 Four Possible Buyers Willingness to Pay

For a mint-condition recording of Elvis Presleys first album

Consumer Surplus
Consumer surplus is the buyers willingness to pay for a good minus the amount the buyer actually pays for it.
Example: If the Elvis albums price is $75 Buyer John Willingness Consumer Buy? to Pay Surplus 100 25 Yes

Paul 80 George 70 Ringo 50

5 -5 -25

Yes No No
11

Market Demand
The market demand schedule/curve shows the various quantities that buyers would be willing and able to purchase at different prices.
Chapter 4

We can use the willingness-to-pay numbers to calculate the quantities demanded at every price
That is, we can calculate the market demand schedule/curve from the willingness-to-pay numbers
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 12

Buyer

The Demand Schedule

Willingness to Pay 100 80

John Paul

George 70

Ringo

50

13

Buyer

Willingness to Pay 100 80 50

Figure 1 The Demand Curve

Price of Album

John Paul Ringo

George 70 John s willingness to pay

$100

80 70

Paul s willingness to pay George s willingness to pay

50

Ringo s willingness to pay

The height of the demand curve at any quantity shows the willingness to pay of whoever bought the last unit.

Demand

Quantity of Albums
Copyright2003 Southwestern/Thomson Learning

Area of a Rectangle

Area = Width Height

Height

Width
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 15

Figure 2 Measuring Consumer Surplus with the Demand Curve Buyer Willingness Consumer
to Pay John (a) Price = $80.01 Price of Album $100 Paul George Ringo 100 80 70 50 Surplus 20 0 -10 -30

Buy? Yes No No No

80 70 50

1. The area under the demand curve measures the total willingness to pay for the quantity demanded. 2. It is also the maximum willingness to pay that could be generated from that quantity. Demand

0 Johns willingness to pay ($100)

Quantity of Albums

The market and the planner

Suppose the government has one copy of the Elvis album. The governments goal is to give it to one of the four guys so as to generate the maximum happiness. Who will get the governments copy? Obviously, John. Lesson: The market does the best that the government could have done
Price = $80 Buyer John Paul George Ringo Willingness to Pay 100 80 70 50

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Figure 2 Measuring Consumer Surplus with the Demand Curve Buyer Willingness Consumer
to Pay John (b) Price = $70.01 Price of Album $100 Paul George Ringo 100 80 70 50 Surplus 30 10 0 -20

Buy? Yes Yes No No

80 70

1. The area under the demand curve measures the total willingness to pay for the quantity demanded.

50

2. It is also the maximum willingness to pay that could be generated from that quantity. Demand

0 Johns willingness to pay

4 Quantity of Albums Pauls willingness to pay 2 3

Interpersonal comparability
We just saw
that the total area under the demand curve is $180, and that is also the total willingness to pay of John and Paul

But can we say it is the total happiness of John and Paul? Yes,
if there is a commoditysay, a bag of potato chipsthat provides an unchanging amount of happiness to the consumer, and if Johns happiness and Pauls happiness are comparable, and if both John and Paul get the same happiness from a bag of potato chips

Thats a lot of ifs! But we will make these simplifying assumption anyway
Not just for John and Paul, but for everybody
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 19

Utilitarianism
The idea that
the happiness of an individual can be measured numerically, the happiness of a group of people can be measured numerically, the happiness of a group of people is simply the sum of the numbers representing the happiness of the individual members of the group, and that social policy should seek to maximize the total happiness of society, is called utilitarianism

The welfare analysis in this chapter takes utilitarianism as its guiding philosophy
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 20

The market and the planner

Suppose the government has two copies of the Elvis album. The governments goal is to give them to two of the four guys so as to generate the maximum happiness. Who will get the governments copies? Obviously, John and Paul. The market does the best that the government could have done
Price = $70 Buyer John Paul George Ringo Willingness to Pay 100 80 70 50

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21

Willingness to Pay from the Demand Curve

(a) Willingness to Pay at Price P Price A

The area under the demand curve also measures the maximum willingness to pay that could be obtained from Q1 units
P1 B C

Demand

Q1

Quantity

Using the demand curve to measure willingness to pay

In general, the area under the demand curve up to the quantity demanded is a graphical measure of the total willingness to pay of the buyers. It is also the maximum willingness to pay that can be obtained from that quantity
That is, the government could not give away that quantity in a way that generates higher willingness to pay.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 23

Figure 3 How the Price Affects Consumer Surplus

(a) Consumer Surplus at Price P Price A

Consumer Surplus (ABC) + Total Payment (OBCQ1) = Willingness to Pay (OACQ1)

Consumer surplus P1 B Total Payment C

Demand

Q1

Quantity

Using the Demand Curve to Measure Consumer Surplus

In general, the area below the demand curve and above the price measures the consumer surplus.

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28

Figure 3 How the Price Affects Consumer Surplus

(b) Consumer Surplus at Price P Price A

Initial consumer surplus P1 C B

Consumer surplus to new consumers

P2

F D E Additional consumer surplus to initial consumers Demand

Q1

Q2

Quantity

Shifts in Demand
We have seen that the demand curve can shift, for reasons such as
a change in tastes, and a change in the prices of related goods
See chapter 4

Given that the demand for a product can shift as a result of a change in the price of a related good, does it make sense to say that the area under the demand curve measures the happiness consumers get from the product?
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 30

Shifts in Demand
Continued from the previous slide Yes!
Keep in mind that the area under the demand curve is a monetary measure of the happiness obtained by buyers The objective or psychological happiness obtained from a shirt may be unchanged even if the monetary willingness to pay for the shirt changes, perhaps because of a change in the price of a related good

In an earlier slide, a bag of potato chips was assumed to always provide 3 haps of happiness, and sold at a price of $0.50. Consequently, consumers were wiling to pay $15 for a shirt that provided 90 haps of happiness. It follows that if the price of a bag of potato chips rises to $1, consumers would then be willing to pay $30 for the same shirt, leading to an upward shift in the demand curve for shirts.

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Producer Surplus
Producer surplus is the amount a seller is paid for a good minus the sellers cost. It measures the net benefit to sellers It is almost but not quite the same as profit.
Well discuss this later

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Cost of production
The cost of production is the market value of all resources used in production
By all, I do mean all. Even if some resources used in production were obtained for free, their market value must be included in cost.

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Table 2 The Cost of Painting a House for Four Possible Sellers

The Supply Schedule and the Supply Curve

Seller Mary Frida Georgia

Cost ($) 900 800 600

Grandma 500

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36

Figure 4 The Supply Schedule and the Supply Curve

Seller Mary
The height of the supply curve at any quantity shows the production cost to whoever produces the last unit.

Cost ($) 900 800

Frida

Georgia

600

Grandma 500

Producer Surplus
Producer surplus is the amount a seller is paid minus the sellers cost
Example: If the going price for getting a house painted is $700 we get the following table. Seller Mary Frida Cost ($) Producer Surplus 900 800 -200 -100 100 200 Sell? No No Yes Yes
38

Georgia 600 Grandma 500

CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

Using the Supply Curve to Measure Producer Surplus

The area below the price and above the supply curve measures the producer surplus.

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39

Figure 5 Measuring Producer Surplus with the Supply Curve (a) Price = $599.99
Price of House Painting Supply 1. The area under the supply curve is the cost of the quantity supplied 2. It is also the lowest cost for that quantity Seller Cost ($) Producer Surplus 900 800 -300 -200 Sell? No No

$900 800

600
500

Mary Frida

Georgia
Grandmas Cost ($500)

600

0
100

No
Yes

Grandma 500

4 Quantity of Houses Painted

Is there a better alternative to the market system?

If the government had to get one house painted, who would get the job? Grandma, of course, if the government had any sense. And thats exactly what happens in the market outcome. The market achieves the best that the government could have achieved
Seller Cost ($)

Mary
Frida Georgia

900
800 600

Grandma 500

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43

Figure 5 Measuring Producer Surplus with the Supply Curve (b) Price = $799.99
Price of House Painting Supply 1. The area under the supply curve is the cost of the quantity supplied 2. It is also the lowest cost for that quantity

$900

800
600 500 Seller Mary Cost ($) Producer Surplus 900 -100 Sell? No

Frida
Georgia

800
600

0
200 300

No
Yes Yes

Grandma 500

0 Grandmas cost

1 Georgias cost

4 Quantity of Houses Painted

Is there a better alternative to the market system?

If the government had to get two houses painted, who would get the job? Grandma and Georgia, of course. And thats exactly what happens in the market outcome. The market achieves the best that the government could have achieved
Seller Cost ($)

Mary
Frida Georgia

900
800 600

Grandma 500

CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

45

Figure 6 How the Price Affects Producer Surplus

(a) Producer Surplus at Price P Price Supply

P1

B Producer surplus C
Total Revenue (OBCQ1) = Production Cost (OACQ1) + Producer Surplus (ABC)

A 0

Production Cost

Q1

Quantity

Figure 6 How the Price Affects Producer Surplus

(b) Producer Surplus at Price P Price Additional producer surplus to initial producers D Supply

E
F

P2

P1

B Initial producer surplus C Producer surplus to new producers

A 0 Q1 Q2 Quantity

MARKET EFFICIENCY
Consumer surplus and producer surplus may be used to address the following questions:
Is our free market system a good way of running our economy? Could we design a better system?

CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

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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
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 50

MARKET EFFICIENCY
Total surplus = Consumer surplus + Producer surplus = Value to buyers Amount paid by buyers + Amount received by sellers Cost to sellers = Value to buyers Cost to sellers

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MARKET EFFICIENCY
In fact, we can go further and say that Total Surplus = maximum willingness to pay minimum production cost

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52

MARKET EFFICIENCY
An economic outcome is efficient if there is no feasible way to make the total surplus any higher.

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53

Figure 7 Consumer and Producer Surplus in the Market Equilibrium

Price A D

Supply

Consumer surplus Equilibrium price Producer surplus E

B C 0 Equilibrium quantity

Demand

Quantity

Figure 7 Consumer and Producer Surplus in the Market Equilibrium

Price A Total Value (or, willingness to pay) Total Surplus Equilibrium price Producer surplus D

Supply

Consumer surplus E

B Cost C 0 Equilibrium quantity

Demand

Quantity

The best feasible outcome

Price A Total Value (also, Maximum Value) Maximum Total Surplus Equilibrium price Producer surplus D

Supply

Consumer surplus E

As long as we produce the equilibrium quantity, it would be impossible to increase the Total Surplus by reallocating production and consumption.

C 0

Cost (also, Minimum Cost) Equilibrium quantity

Demand

But is the equilibrium output the right output to produce?

Quantity

The best feasible outcome

Price A Minimum WTP lost D

Supply

Equilibrium price

Society would be worse off if it produces less than the equilibrium quantity

Maximum Cost saved C 0 Alternative Equilibrium quantity

Demand

Quantity

The best feasible outcome

Price A D

Supply

Equilibrium price

Society would be worse off if it produces more than the equilibrium quantity

C 0

Maximum Value of extra output

Minimum Cost

Demand

Equilibrium quantity

Alternative

Quantity

MARKET EFFICIENCY
Three Insights Concerning Market Outcomes
Free markets allocate the goods produced to the buyers who value them most highly, as measured by their willingness to pay. Free markets allocate production of goods to those who can produce them at least cost. Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 59

Figure 8 The Efficiency of the Equilibrium Quantity

Price Supply

Value to buyers

Cost to sellers

Cost to sellers 0 Equilibrium quantity

Value to buyers is greater than cost to sellers.

Value to buyers

Demand

Quantity

Value to buyers is less than cost to sellers.

The Invisible Hand

We pursue our self-interest, not the social interest It is, therefore, natural to think that the free market would lead to chaos And yet, as we just saw, the free market outcome is unimprovable This idea was most famously proposed by Adam Smith (1723 1790), the father of modern economics.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 62

The Invisible Hand

...[E]very individual neither intends to promote the public interest, nor knows how much he is promoting it. [H]e intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. The Wealth of Nations, Adam Smith, 1776
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 63

Ticket Scalping
Ticket scalping is often frowned upon and sometimes considered illegal
See http://en.wikipedia.org/wiki/Ticket_resale

But a typical view among economists is that consenting adults should be able to make economic trades when they think it is to their mutual advantage Scalping increases the economys efficiency
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 64

Market for organs

Should people be allowed to sell, say, their kidneys? The efficiency of the economy will increase. What about fairness?
Rich will buy the kidneys; the poor will not. But Right now healthy people have extra kidneys while the sick have none. The sale of organs may be more acceptable if organ purchases by the poor were paid for with taxpayers money so that rich and poor had equal access
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 65

WHEN MARKETS FAIL

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66

However, markets can go wrong

Market Power Externalities Fairness

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67

MONOPOLY
If a market system is not perfectly competitive, firms may have market power.
Market power is the ability to influence prices. Market power can cause markets to be inefficient because it keeps price and quantity from the equilibrium of supply and demand.

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68

EXTERNALITIES
Externalities are 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 externalities into account when deciding how much to consume and produce, the equilibrium in the market can be inefficient.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 69

FAIRNESS
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. The free market economic system is efficient but not necessarily fair

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70

Health Care: a big exception

In most advanced countries, government policies regarding health care routinely disregard the idea that free markets are best In the United Kingdom, the government builds hospitals, hires doctors and nurses, buys pharmaceutical drugs, and provides medical care to all residents Patients get no bills; tax revenues are used to pay all costs Fees of private doctors are paid by the government Performance indicators are high Costs are low There is virtually no clamor for privatization
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 71

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.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 72

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.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 73

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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74

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.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 75