Nechyba 2e CH 15AB PDF

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Microeconomics:
An Intuitive Approach, 2E
Chapter 15 –
The “Invisible Hand”
and the First Welfare Theorem
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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved
learning management system for classroom use.
Consumer and
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Master titleSurplus
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• We know that individual consumer surplus can be measured as the area
underneath the compensated demand curve and above the price at which
a consumer consumes.
• But unless consumer tastes for the good that we are analyzing are
borderline between normal and inferior (and tastes are thus quasilinear in
the good of interest), the compensated demand curves for individual
consumers are different from their regular demand curves.
• We cannot, then, illustrate the total consumer surplus for all the
consumers in a market along the market demand curve that we use to
drive the equilibrium.
• While the market demand curve therefore allows us to predict behavior, it
is not typically the right curve on which to measure consumer surplus.
• If we think of a representative consumer, and assume a certain
indifference map for that consumer, we can derive not only the observable
market demand curve but also the compensated market demand curve on
which we measure consumer surplus.
© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website or
school-approved learning management system for classroom use.
A Click
“Representative”
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© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,except for use as permitted in a license distributed with a certain
product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
When a group of individuals behaves “as if” it were a single rational individual, we say
that the group can be modeled as a representative consumer.
Consider, for instance, the group composed of Person 1 and Person 2 who individually
optimize at A1 and A2 on their respective budgets.
For us to be able to treat this group as a representative consumer, it can’t
matter for the overall consumption bundle how income is distributed
between the two people.
Suppose, for instance, that we redistribute $200 from Person
1 to Person 2.
The only way this does not impact the overall bundle of
the group is if the change in Person 1’s bundle is exactly
offset by the change in Person 2’s bundle.
Person 1’s Budget
And this only happens if the
“arrows” in the graph are parallel
New Budget for Both to one another.
Person 2’s Budget
Aggregating
ClickConsumers with Quasilinear
to edit Master title style Tastes
© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain
Quasilinearity is one condition on tastes that allows us to represent groups as

representative consumers.
If tastes are quasilinear in x1, we can redistribute income within the group …
… and each individual will continue to purchase the same amount of

x1 while adjusting only consumption of x2.
The changes in individual behavior therefore exactly

offset one another – and overall group consumption
remains unchanged (so long as no group member is at a
corner solution).
The resulting representative consumer

then also has quasilinear tastes.
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Surplus
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When we can reasonably assume that consumer tastes are quasilinear in some good X, we
can therefore treat the market demand curve as if it arose from the choices of a single
representative consumer whose tastes are quasilinear in X.
Since Quasilinearity removes income effects, we can then treat the market demand curve as
a marginal willingness to pay curve on which consumer surplus can be measured.
The analogous holds for worker surplus when tastes are quasilinear in leisure.
Short-Run Profit
Click to editor SR Producer
Master Surplus
title style
To see how producer surplus (or profit) can be measured on the market supply curve, we
begin by asking how much surplus a firm would get if it produced at the lowest point of AC.
Revenu – Cost = Profit (or Producer Surplus)
e
A profit-maximizing firm will of course
produce where p* = MC – giving
additional producer surplus for the
additional output above xA.
Combining these, we get producer

surplus as an area to the left of the
firm’s supply curve.
Since there are no income effects

to get in the way of aggregating
across firms, this implies that we
can measure producer surplus on
the market supply curve.
Short-Run
ClickProducer Surplus in
to edit Master Labor
title Markets
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The (short run) labor demand curve is a portion of the marginal revenue product (of labor)
curve.
It begins at the wage ωA – the “break even wage”. If the actual wage is ω*< ωA, the firm
earns an average of (ωA – ω*) of profit per worker hour up to l A .
*
By hiring workers all the way up to l , the additional
profit earned is the shaded magenta area.

 us producer surplus in the

This gives
labor market as the area to the left
(and underneath) the labor demand
curve …
… which also aggregates to an

area to the left of the market
labor demand curve.
Surpluses in Output & Labor Markets, Quasilinear Tastes
The total surplus in the market is then most easily illustrated under the assumption of
quasilinear tastes – an assumption implicitly made in Econ 1 courses.
For which of these areas is the quasilinearity assumption needed?

For the Consumer Surplus and Worker Surplus areas.
A SocialClick
Planner Finding
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Master Output x”
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Economists often use the conceptual tool of a benevolent and omniscient Social Planner to
compare market outcomes to some “ideal”.
If, for instance, a social planner wanted to maximize total surplus, the planner would compare
the marginal social costs (MSC) to the marginal social benefits (MSB) of production.
Under certain conditions, the MSC of the

first output is its marginal production cost
MC, and the MSB of that output unit is the
MWTP of the representative consumer.
The marginal surplus (MWTP – MC) is

positive until MSB and MSC cross …
… and negative thereafter.
The social planner’s optimal

production level x* is then the
same as the market output level
in this case.
The 1stClick
Welfare Theorem
to edit with
Master General
title styleTastes
© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or inpart, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
The first welfare theorem states that, under “certain conditions”, competitive markets
achieve efficient outcomes (that maximize surplus). While most easily illustrated in the
case of quasilinear tastes, the theorem holds more generally.
Suppose the good under consideration is a normal good.
We can then add up both the individual

demand curves and the MWTP curves.
And, even though consumer surplus is

now measured on the distinct MWTP
curve …
… overall surplus is still maximized at the
intersection of supply and demand.
The subtle complication is that

the output level XA is now optimal
for the social planner “given the
income distribution”.
SocialtoPlanner
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edit Master Market
style
© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a
The “social planner” is just a conceptual tool – a “real world” social

planner would have to be virtually omniscient and fully benevolent to
reach the market outcome.
In contrast, the market relies on everyone simply “doing the best they
can given their circumstances”.
The information required by the social planner is conveyed in the market
through prices that coordinate consumers and firms.
Thus, no one needs to know more than their individual circumstances –
and the order that emerges from decentralized decisions is a
spontaneous order.
There is furthermore no need to rely on anyone’s benevolence in the
market – because market transactions are voluntary and based on
mutual gain.
1st Click
Welfare Theorem
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titleitsstyle
Limits
The first welfare theorem can be demonstrated in many more general

settings. But the underlying assumptions are always the following:
1. There are no policy-induced price distortions.
2. All private property rights are established, eliminating all externalities.
3. There is no asymmetric information between buyers and sellers.
4. Everyone is “small” – i.e. no one has market power.
In addition, we should keep in mind that the theorem is about efficiency

and not about other values (such as “equity” or “fairness”).
This – and the underlying conditions of the theorem – outline the potential
role for non-market institutions like government and the civil society.
1st Welfare
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Representative
Click Consumer
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n
Let superscripts denote individuals and subscripts denote goods; i.e. x i is individual n’s
consumption of good i.
Income-redistribution within a group leaves the overall consumption choice of the group
unaffected (allowing us to treat the group as if it were a single consumer) if and only if

The only demand functions that satisfy this are functions that
take the form
m n
where ai and ai are functions that are
Person 1’s Budget both person-specific and good-specific,
but bi is a function that can only be
Person 2’s Budget
New Budget for Both goods-specific.
 
Representative
Click Consumer
Tastes that give rise to such demands are known as satisfying the Gorman form.
One special case is the case of quasilinear tastes that can be represented
by a utility function of the form
Since there are no income effects relative to good 1, the demand

function for good 1 is not a function of income – implying
Back to Graphs
Aggregate Consumer
Click to edit Surplus
Master title style
When tastes are quasilinear, the market demand curve can then be treated as if it had
emerged from a single representative consumer whose uncompensated demand
function is the same as her compensated demand function.
This allows us to measure consumer surplus on the market demand curve …
… or calculated it as an integral on the market demand function.
But if tastes are not quasilinear, consumer surplus is measured on compensated demand:
Aggregate Producer
Click to Surplus
edit Master (or Profit)
title style
Producer Surplus is always measured on the market supply curve …

… or calculated as an integral on the market supply function. This is true both in the SR and
LR:
In the long run, of

course, producer
surplus is zero if all
firms are identical.
15B Equilibrium Welfare
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edit Master Preliminaries
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and an Example
15B.1 Consumer Surplus
– For the special case of quasilinear tastes, you can treat
market demand by a single “representative consumer”
15B.1.1 “Representative” Consumers
– Consider again the example of the aggregated household
demand for me and my wife, and whether it can be treated
as if it had arisen from rational “household tastes.” Letting
me be denoted by the superscript n and my wife by the
superscript m:
– With a little work, we can see that the demand functions
must take the form:
15B.1.2 The Special Case of Quasilinear Tastes
– Graph 15.2 demonstrated that changes in individual demand
(for both x1 and x2) exactly offset one another as income is
redistributed
– We know that both of our demand functions for x1 are not a
function of income, while our demand for x2 is determined
by the income left over after we purchase the amount of x1
(that does not depend on our income):
15B.1.3 Aggregate Consumer Surplus
– Individual consumer surplus in the market for good x can be
measured as the area below the MWTP curve down to the
price; expressed mathematically:
15B.2 Producer
Click toSurplus
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- Profit (producer surplus) can be measured as an area on
supply curves; Put into equations for a single form:
- Using equations (13.31) and (13.33), we derived the

following short-and long-run input demand and output
supply functions for each of the firms:
- We can calculate short-and long-run producer surplus as:
15B.3 First Welfare
Click Theorem
- Consider again the optimization problem faced by the
fictional benevolent social planner “Barney” from Sec A
- If we now know a utility function U(x,y) that can represent
the “representative consumer’s” tastes, we could write
Barney’s problem of attempting to maximize social surplus in
the world as:
15B.2 Producer
Click toSurplus
edit Master title style
- Profit (producer surplus) can be measured as an area on
individual (& aggregate) supply curves; Put into equations
for a single form:
- Using equations (13.31) and (13.33), we derived the

following short-and long-run input demand and output
supply functions for each of the firms:

– xx

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Click to edit Master title style

Quasilinearity is one condition on tastes that allows us to represent groups as

… and each individual will continue to purchase the same amount of

The changes in individual behavior therefore exactly

The resulting representative consumer

Combining these, we get producer

Since there are no income effects

 us producer surplus in the

… which also aggregates to an

For which of these areas is the quasilinearity assumption needed?

Under certain conditions, the MSC of the

The marginal surplus (MWTP – MC) is

The social planner’s optimal

We can then add up both the individual

And, even though consumer surplus is

The subtle complication is that

The “social planner” is just a conceptual tool – a “real world” social

The first welfare theorem can be demonstrated in many more general

In addition, we should keep in mind that the theorem is about efficiency

Since there are no income effects relative to good 1, the demand

Producer Surplus is always measured on the market supply curve …

In the long run, of

- Using equations (13.31) and (13.33), we derived the

- We can calculate short-and long-run producer surplus as:

- Using equations (13.31) and (13.33), we derived the

15B.1 Consumer Surplus

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