Consumers, Producers and

the Efficiency of Markets

Credit
N. Gregory Mankiw
 What is consumer surplus? How is it related
to the demand curve?

In this lecture we look

for the answers to What is producer surplus? How is it related to
the supply curve?
these questions:

Do markets produce a desirable allocation of

resources? Or could the market outcome be
improved upon?
 ▪ Recall, the allocation of resources refers to:

• how much of each good is produced

WELFARE • which producers produce it

ECONOMICS • which consumers consume it

▪ Welfare economics studies how the allocation of

resources affects economic well-being.

▪ First, we look at the well-being of consumers.

Willingness to Pay (WTP) and the Demand Schedule

▪ A buyer’s willingness to Name WTP Q: If price of iPod is

pay for a good is the $200, who will buy an
Ankur $250 iPod, and what is
maximum amount the
quantity demanded?
buyer will pay for that Azra 175
A: Ankur and Pawan
good. Pawan 300 will buy an iPod, Azra
▪ WTP measures how much and Riddhi will not.
Riddhi 125
the buyer values the good. Hence, Qd= 2
Example:
4 buyers’ WTP for an iPod when P = $200.
Willingness to Pay (WTP) and the Demand Curve

Name WTP P (Price of iPod) $ Who Buys Qd

Ankur $250 301 & Up Nobody 0

251 - 300 Pawan 1

Azra 175
176 - 250 Pawan and Ankur 2
Pawan 300
126 - 175 Pawan, Ankur, Azra 3
Riddhi 125
0 - 125 Riddhi, Azra, Ankur and Pawan 4
Drive the Demand Schedule
WTP and the Demand Curve
P
$350
P Qd
$300
$250 $301 & up 0

$200 251 – 300 1

$150 176 – 250 2
$100
126 – 175 3
$50
0 – 125 4
$0 Q
0 1 2 3 4
About the Staircase Shape…
P
This D curve looks like a staircase
$350 with 4 steps – one per buyer.
$300 If there were a huge number of
$250 buyers, as in a competitive market,

$200 there would be a huge number

of very tiny steps,
$150
$100 and it would look more
like a smooth curve.
$50
$0 Q
0 1 2 3 4
WTP and the Demand Curve
P
Pawan’s WTP At any Q,
$350
the height of
$300 Ankur’s WTP
the D curve is the WTP of the
$250 Azra’s WTP marginal buyer, the buyer
$200 Riddhi’s who would leave the market
WTP if P were any higher.
$150
$100
$50
$0 Q
0 1 2 3 4
Consumer Surplus (CS)
Consumer surplus is the amount a buyer is willing to pay minus the
amount the buyer actually pays:

CS = WTP – P

Name WTP Suppose P = $260.

Pawan’s CS = $300 – 260 = $40.
Ankur $250
The others get no CS because they
Azra 175
do not buy an iPod at this price.
Pawan 300
Total CS = $40.
Riddhi 125
CS and the Demand Curve
P
Pawan’s WTP
$350 P = $260
$300 Pawan’s CS =
$250
$300 – 260 = $40
$200
Total CS = $40
$150
$100
$50
$0 Q
0 1 2 3 4
CS and the Demand Curve
P
Pawan’s WTP Instead, suppose
$350
$300 Ankur’s WTP P = $220

$250 Pawan’s CS =
$200 $300 – 220 = $80
$150
Ankur’s CS =
$100
$250 – 220 = $30
$50
$0 Total CS = $110
Q
0 1 2 3 4
CS and the Demand Curve
P
$350
$300 The Lesson:
$250
Total CS equals the area under
$200
the demand curve above the
$150
price, from 0 to Q.
$100
$50
$0 Q
0 1 2 3 4
CS with Lots of Buyers & a Smooth D Curve
At Q = 5(thousand), the Price P
marginal buyer is willing per pair The demand for shoes
$ 60
to pay $50 for pair of
shoes. 50

Suppose P = $30. 40

Then his consumer surplus 30

1000s of pairs
= $20. 20 of shoes
10
D
0 Q
0 5 10 15 20 25 30
CS with Lots of Buyers & a Smooth D Curve
P
The demand for shoes
CS is the area b/w P and the D $ 60
curve, from 0 to Q. 50
h
Recall: area of a triangle equals 40
½ x base x height 30

Height = $60 – 30 = $30. 20

So, 10
D
CS = ½ x 15 x $30 0 Q
= $225. 0 5 10 15 20 25 30
How a Higher Price Reduces CS
P
If P rises to $40,
60 1. Fall in CS due to
CS = ½ x 10 x $20 buyers leaving market
50
= $100.
40
Two reasons for the fall in CS.
30

2. Fall in CS due to 20
remaining buyers 10
paying higher P D
0 Q
0 5 10 15 20 25 30
Consumer Surplus
Demand Curve
P
50
A. Find marginal buyer’s WTP at
Q = 10. $ 45
40
B. Find CS for
P = $30. 35
30
Suppose P falls to $20. 25
How much will CS increase due to…
20
C. buyers entering the market 15
D. existing buyers paying lower price 10
5
0
0 5 10 15 20 Q
25
Answers
Demand Curve
P
50
A. At Q = 10, marginal buyer’s $ 45
WTP is $30.
40
B. CS = ½ x 10 x $10 35
= $50
30
P falls to $20. 25
C. CS for the additional buyers 20
= ½ x 10 x $10 = $50 15
D. Increase in CS on initial 10 units 10
= 10 x $10 = $100 5
0
0 5 10 15 20 Q
25
Cost and the Supply Curve
Cost is the value of everything a seller must give up to produce a good (i.e.,
opportunity cost).

• Includes cost of all resources used to produce good, including value of the
seller’s time.

• Example: Costs of 3 sellers in a……… business.

Name Cost A seller will produce and sell the good/service

Ifa $10 only if the price exceeds his or her cost.
Sumit 20 Hence, cost is a measure of willingness to sell.
Yamin 35
Cost and the Supply Curve

Derive the supply schedule P ($) Who Sells Qs

from the cost data:
0-9 Nobody 0
Name Cost
10-19 Ifa 1
Ifa $10

Sumit 20 20-34 Ifa and Sumit 2

Yamin 35 35 & Up Ifa, Sumit and Yamin 3

Cost and the Supply Curve
P
$40 P Qs

$0 – 9 0
$30
10 – 19 1
$20
20 – 34 2
$10 35 & up 3

$0 Q
0 1 2 3
Cost and the Supply Curve
P
$40 At each Q, the height
Yamin’s
cost of the S curve is the
$30 cost of the marginal
Sumit’s
$20 seller, the seller who
cost
would leave the
$10 Ifa’s cost
market if the price

$0 Q were any lower.

0 1 2 3
Producer Surplus
P
PS = P – cost
$40

$30
Producer surplus (PS): the
amount a seller is paid for a
$20
good minus the seller’s cost

$10

$0 Q
0 1 2 3
Producer Surplus and the S Curve
P PS = P – cost
$40 Suppose P = $25.
Yamin’s
cost ▪ Ifa’s PS = $15
$30
Sumit’s ▪ Sumit’s PS = $5
$20 cost
▪ Yamin’s PS = $0
$10 Ifa’s cost ▪ Total PS = $20

Q Total PS equals the area above

$0
the supply curve under the price,
0 1 2 3
from 0 to Q.
PS with Lots of Sellers & a Smooth S Curve
Price P
per pair The Supply of Shoes
60
Suppose P = $40. 50 S

At Q = 15 (thousand), the 40

marginal seller’s cost is $30, 30

1000s of pairs
and his producer surplus is 20 of shoes
$10. 10
0 Q
0 5 10 15 20 25 30
PS with Lots of Sellers & a Smooth S Curve
PS is the area b/w P The Supply of Shoes
P and the S curve, from 0 60
to Q. S
50
The height of this triangle
40
is
$40 – 15 = $25. 30
h
So, 20
PS = ½ x b x h 10
= ½ x 25 x $25
0 Q
= $312.50
0 5 10 15 20 25 30
How a Lower Price Reduces PS
If P falls to $30, P 1. Fall in PS due to
PS = ½ x 15 x $15 60 sellers leaving
market S
= $112.50 50

Two reasons for the 40

fall in PS. 30

2. Fall in PS due to 20
remaining sellers 10
getting lower P
0 Q
0 5 10 15 20 25 30
Producer Surplus Supply Curve
P
50
A. Find marginal seller’s cost 45
at Q = 10. 40
35
B. Find total PS for P = $20. 30
25
Suppose P rises to $30. 20
Find the increase in PS due to: 15
10
C. Selling 5 additional units.
5
D. Getting a higher price on 0
the initial 10 units. 0 5 10 15 20 Q
25
Answers
Supply Curve
A. At Q = 10, P
50
marginal cost = $20 45
40
B. PS = ½ x 10 x $20
35
= $100
30
P rises to $30. 25
C. PS on additional units 20
= ½ x 5 x $10 = $25 15
10
D. Increase in PS on initial 5
10 units 0
= 10 x $10 = $100 0 5 10 15 20 Q
25
CS, PS, and Total Surplus

CS = (value to buyers) – (amount paid by buyers)

= buyers’ gains from participating in the market
PS = (amount received by sellers) – (cost to sellers)
= sellers’ gains from participating in the market
Total Surplus = CS + PS
= total gains from trade in a market
= (value to buyers) – (cost to sellers)
The Market’s Allocation of Resources

▪ In a market economy, the allocation of resources is decentralized,

determined by the interactions of many self-interested buyers and sellers.

▪ Is the market’s allocation of resources desirable? Or would a different

allocation of resources make society better off?

▪ To answer this, we use total surplus as a measure of society’s well-being,

and we consider whether the market’s allocation is efficient.

▪ Policymakers also care about equality, though our focus here is on

efficiency.
Efficiency
Total
surplus = (value to buyers) – (cost to sellers)

An allocation of resources is efficient if it maximizes total surplus.

Efficiency means:
▪ The goods are consumed by the buyers who value them most highly.

▪ The goods are produced by the producers with the lowest costs.

▪ Raising or lowering the quantity of a good would not increase total surplus.
Evaluating the Market Equilibrium
Market equilibrium: P
P = $30 60
50 S
Q = 15,000
40 CS
Total surplus
30
= CS + PS PS
20
Is the market equilibrium efficient? 10
D
0 Q
0 5 10 15 20 25 30
Which Buyers Consume the Good?
P
Every buyer whose WTP is
60
≥ $30 will buy.
50 S
Every buyer whose WTP is
40
< $30 will not.
30
So, the buyers who value the
20
good most highly are the ones
10
who consume it. D
0 Q
0 5 10 15 20 25 30
Which Sellers Produce the Good?
P
Every seller whose cost is ≤ $30 60
will produce the good. 50 S

Every seller whose cost is > $30 40

will not. 30
20
So, the sellers with the lowest
10
cost produce the good. D
0 Q
0 5 10 15 20 25 30
Does Equilibrium Q Maximize Total Surplus?
P
At Q = 20,
60
cost of producing the marginal unit is S
50
$35
40
value to consumers of the marginal unit
30
is only $20
20
Hence, can increase total surplus by
10
reducing Q. D
0 Q
This is true at any Q greater than 15.
0 5 10 15 20 25 30
Does Equilibrium Q Maximize Total Surplus?
At Q = 10, P
cost of producing the marginal unit 60
is $25 S
50
value to consumers of the marginal 40
unit
30
is $40
20
Hence, can increase total surplus
10
by increasing Q. D
0 Q
This is true at any Q less than 15.
0 5 10 15 20 25 30
Does Equilibrium Q Maximize Total Surplus?
▪ If the product price is higher than the market price, then the P
producer surplus increases, but only at the expense of the
consumer surplus. 60
▪ If the price is lower than the market price, then consumers 50 S
enjoy increased consumer surplus, but only at the expense of
the producers. 40
▪ Of course, this assumes that the buyers will buy the entire
quantity at the higher price or that producers will produce the
30
quantity demanded at the lower prices.
20
▪ However, a price higher than the market price will lead to a
surplus, because the price is higher than what many consumers 10
are willing to pay, and if the price is below the market price, D
then shortages will be created, because at lower prices, 0 Q
producers are only willing to produce a quantity that is less than
0 5 10 15 20 25 30
demand. So, in actuality, shortages and surpluses will reduce
The market equilibrium quantity maximizes total surplus: At any
the total surplus. Therefore, total surplus is maximized when
other quantity, can increase total surplus by moving toward the
the price equals the market equilibrium price. market equilibrium quantity.
Market Versus Government
The Free Market vs. Govt Intervention
▪ The market equilibrium is efficient.
▪ No other outcome achieves higher
total surplus.
▪ Govt cannot raise total surplus by
changing the market’s allocation of
resources.
▪ Laissez faire (French for “allow them to
do”): the notion that govt should not
interfere with the market.
The Free Market vs. Central Planning
▪ Suppose resources were allocated not
by the market, but by a central planner
who cares about society’s well-being.
▪ To allocate resources efficiently and
maximize total surplus, the planner
would need to know every seller’s cost
and every buyer’s WTP for every good
in the entire economy.
▪ This is impossible, and why centrally-
planned economies are never very
efficient.
Summary
▪ The height of the D curve reflects the value of the good to buyers—their willingness to pay for it.
▪ Consumer surplus is the difference between what buyers are willing to pay for a good and what they
actually pay.
▪ On the graph, consumer surplus is the area between P and the D curve.
▪ The height of the S curve is sellers’ cost of producing the good. Sellers are willing to sell if the price they
get is at least as high as their cost.
▪ Producer surplus is the difference between what sellers receive for a good and their cost of producing
it.
▪ On the graph, producer surplus is the area between P and the S curve.
▪ To measure society’s well-being, we use total surplus, the sum of consumer and producer surplus.
▪ Efficiency means that total surplus is maximized, that the goods are produced by sellers with lowest
cost, and that they are consumed by buyers who most value them.
▪ Under perfect competition, the market outcome is efficient. Altering it would reduce total surplus.