I I I

N. GREGORY MANKIW
AND MARK P. TAYLOR
r , CENGAGE
'. - Learning.

MICROECONOMICS
N. GREGORY MANKIW
AND MARK P. TAYLOR

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FOURTH EDITION
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..:.CENGAGE
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Microeconomics, 4th Edition @2017, Cengage Learning EMEA

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een whole arket systems help address the three questions all economies have to answer - what is to be
ese curves
produced, how goods and services are produced and who gets what is produced. Having described
i rr:way markets allocate scarce resources we now need to address the question of whether these market
n long-run alocations are desirable. We know that the price of a good adjusts to ensure that the quantity of a good
:;rrpplied equals the quantity demanded. But, at this equilibrium, is the quantity of the good produced and
<;gnsumed too small, too large or just right? ln this chapter we take up the topic of welfare caonot'nics, the
nue of €i0, r;iudy of how the allocation of resources affects economic well-being. Economists use the term well-being
ir good deal and have taken steps to define the term. A UKTreasury EconomicWorking Paper published in
l,t00g (Lepper, L. and McAndrew, S (2003) Developments rn the Economics of WelLbeing.TreasuryWork-
rrrg Paper Number 4) highlighted two main definitions of economic well-being - subjective and oblective
well-being. Subjeetive well-being refers to the way in which people evaluate their own happiness.This
iitcludes how they feel about work, leisure and their response to the events which occur in their lives.
,ritrieetive well-bcing refers to measures of the quality of life and uses indicators such as educational
;rLiainment, measures of the standard of living, life expectancy and so on. Welfare economics uses some
1f the microeconomic techniques we have already looked at to estimate alloeativc efficiency - a meas-
rrre of the utility (satisfaction) derived from the allocation of resources. We have seen how buyers place a
appens to value on consumption in Chapter 5, ref lected in their willingness to pay. Allocative eff iciency occurs when
using the ihe value of the output that firms produce (the benefits to sellers) matches the value placed on that output
iry consumers (the benefit to buyers). Of course, this analysis is also based on the assumplions that
iruyers prefer more to less and thatthey can ranktheir preferences.The model assumes that consumers'
well-being is improved if they have more goods and their total utility increases,
This chapter will look at how market systems allocate resources such that the resulting outcomes are
'e1j icient', This will provide the basis against which we introduce the notion of equity in later chapters. ln
other words, an outcome may be 'eff icient' but to what extent is it fair?

145
146 PART 3 MARKETS, EFFICIENCY AND WELFARE

welfare economics the study of how the allocation of resources affects economic well-being
subjective well-being the way in which people evaluate their own happiness
objective well-being measures of the quality of life using specified indicators.
allocative efficiency a resource allocation where the value of the output by sellers matches the value placed on that
output by buyers

We begin this chapter by examining the benefits that buyers and sellers receive from taking part in a
market. We then examine how society can make these benef its as large as possible. This analysis leads to
the conclusion, accepting the assumptions which underlie the model of the market, that the equilibriurn
of supply and demand maximizes the total benefits received by buyers and sellers.

CONSUMER SURPLUS
We begin our study of welfare economics by looking at the benefits buyers receive from partrcipating in
a market.

Willingness to Pay
lmagine that you own an extremely rare, signed vintage electric guitar which you decide to sell. One way
to do so is to hold an auction.
Four guitar collectors show up for your auction: Lisa, Paul, Claire and Leon. Each of them would
like to own the luitar, but there is a limit to the amount that each is willing to pay for it. Table 71
shows the maximum price that each of the four possible buyers would pay. Each buyer's maximum is
called their willingness to pay, and it measures how much that buyer values the good. Each buyer
has their own value asslgned to the guitar, which is expressed as the price they are wrllrng to pay to
own it. Each will have some upper limit above which they will not be prepared to pay (possibly
because they don't feel the guitar is worth it above that upper limit or because they know they
cannot afford to pay any more). lf the price were below this upper limrt then each would be eager to
buy the guitar.

willingness to pay the maximum amount that a buyer will pay for a good

Four Possible Buyers'Willingness to Pay

Buyer Willingness to pay {€)

Lisa 1000
Paul 800
Claire 700
Leon 500

To sellyour guitar, you begin the bidding at a low price, say €100. Because allfour buyers are willing to
pay much more, the price rises quickly. The bidding stops when Lisa bids €80'1. At this point, Paul, Claire
and Leon have dropped out of the bidding because they are unwilling to bid any more than €800. Lisa pays
you €801 and gets the guitar. Note that the guitar has gone to the buyer who values it most highly.
What benefit does Lisa receive from buying the guitar? Lisa might argue that she has 'found a real
bargain': she was willing to pay €1000 for the guitar but paid only €801 for it. Lisa valued the benefits
from owning the guitar more highly than the money she has had to give up to own it. One way to
express the value of these benef its is in monetary terms. We say that Lisa receives consumer surplus.
 CHAPTER 7 CONSUIVEBS, PRODUCERS AND THE EFFICIENCY OF MARKETS 147

Consumer surplus is the amount a buyer is willing to pay for a good minus the amount the buyer actu-
'getting a bargain' regularly in everyday language. ln economics, a bargain
ally pays for it. We refer to
means paying much less for something than we expected or anticipated and as a result we get a greater
degree of consumer surplus than we expected.
r that

consumer surplus a buyers willingness to pay minus the amount the buyer actually pays
Ipart in a
s leads to
quilibrium
Consumer surplus measures the benefit to buyers of participating in a market. ln this example, Lisa
receives a €199 benef it from participating in the auction because she pays only €801 for a good she values
at €1000. Paul, Claire and Leon get no consumer surplus from particrpating in the auction because they
left without the guitar and without paying anything.
Now consider a different example. Suppose that you had two identical guitars to sell. Again, you auction
them off to the four possible buyers. To keep things simple, we assume that both guitars are to be sold for
;ipating in the same price and that no buyer is interested in buying more than one guitar. Therefore, the price rises
until two buyers are left.
ln this case, the bidding stops when Lisa and Paul bid €701. At this price, Lisa and Paul are each happy
to buy a guitar and Claire and Leon are not willing to bid any higher. Lisa and Paul each receive consumer
surplus equal to their willingness to pay minus the price. Lisa's consumer surplus is €299 and Paul's is €99.
One way Lisa's consumer surplus is higher now than it was previously, because she gets the same guitar but pays
less for it. The total consumer surplus in the market is €398.
rm wOUld
Table 7.1
ximum is
Using the Demand Gurve to Measure Gonsumer Surplus
rch buyer
to pay to Consumer surplus is closely related to the demand curve for a product.To see how they are related, let's
(possibly continue our example and consider the demand curve for guitars.
row they We begin by using the willingness to pay of the four possible buyers to find the demand schedule for
eager to the guitar.The graph in Figure 7.1 shows the demand schedule that corresponds toTable 7'1. lf the price
is above €1000, the quantity demanded in the market is 0, because no buyer is willing to pay that much.
lf the price is between €801 and €1000, the quantity demanded is 1, because only Lisa is willing to pay

r@The Demand Schedule and the Demand Gurve Price ol

The table shows the demand schedule for the buyers in Table 7.1
guitar (€)
The graph shows the conesponding denand curue. Note that the
height 0f the denand curue reflects buyers' willingness t0 pay.
' ,i.;..:
1000 '.tr;!jt-t,,!,rr j : ,a ,,t,
;
Ouantity
800
Price Buyers Demanded
700 j,,, ,,.' ,,,,1i:, r.j,i i:i ,.1

More than €1000 None 0

€801- €1000 Lisa 1
I i. I r:: !.ra!!: :.:.:.r i
willing to 500 i,r . ':\.
€701 - €801 Lisa, Paul 2
rul, Claire €501 - €701 Lisa. Paul, Claire 3
Lisa pays €500 or less Lisa, Paul, Claire, Leon 4
Demand
)ly.
nd a real
benef its
-. way to
01234 Quantity of
guitars
'surplus.
148 PART 3 MARKETS, EFFICIENCY AND WELFARE

such a high price. lf the price is between €70'1 and €801, the quantity demanded is 2, because both Lisa
and Paul are willing to pay the price. We can continue this analysis for other prices as well. ln this way, 16i
demand schedule is derived from the willingness to pay of the four possible buyers.
The graph in Figure 71 shows the demand curve that corresponds to this demand schedule. Note the
relationship between the height of the demand curve and the buyers' willrngness to pay. At any qu6n-
tity, the price given by the demand curve shows the willingness to pay of Lhe marginal buyer, the buysp
who would leave the market flrst if the price were any higher. At a quantity of 4 guitars, for instance, 16u
demand curve has a height of €500, the price that Leon (the marginal buyer) is willing to pay for a guitar.
At a quantity of 3 guitars, the demand curve has a height of €700, the price that Claire (who is now the
marginal buyer) is willing to pay.
Because the demand curve reflects buyers' willingness to pay, we can also use it to measure cohsufisp
surplus. Figure7.2 uses the demand curve to compute consumer surplus in our example, ln panel (a), the
price is €801 and the quantity demanded is '1. Note that the area above the price and below the demand
curve equals €199 (€1000 - 801 x'1).This amount is exactly the consumer surplus we computed earlier
when only '1 gultar was sold.
Panel (b) of Figure 72 shows consumer surplus when the price is €70'1. ln this case, the area above the
price and below the demand curve equals the total area of the two rectangles: Lisa's consumer surplus
at this price is €299 and Paul's is €99. This area equals a total of €398. Once again, this amount is the
consumer surplus we computed earlier.
The area below the demand curve and above the price measures the consumer surplus in a
market. The height of the demand curve multiplied by the quantity measures the value buyers place
on the good, as represented by their willingness to pay for it. The difference between this willingness
to pay and the market price is each buyer's consumer surplus.Thus, the total area below the demand
curve and above the price is the sum of the consumer surplus of all buyers in the market for a good
or service.

Measuring Consumer Surplus with the Demand Gurve

tnpanet (a) thepriceof thegoodis€801 andtheconsumersurplusis€199. lnpanel (b) thepriceof thegoodis€701 andtheconsuner
surplus is €398.

Price of Price of
guitars (€) guitars (€)

1 000 ,rti:rit rt,j;l:ii,:tr :: !.i

1 000
'l li:i...1:ii,i,,l,::irit::! j., i.'lii:j' t,.'l:lr'.
:ai. . l,r'.,
801 " ,:r r, l,:;r: !'' ,: r ii l
801
701
701
,.!:ir i,i,ili'l il
I r i':;!. ir' r'i :i ,1 .
501 501

Demand
Demand

0 1 2 3 4 0 1 23 Quantity of
Quantity ot guitars
guitars
(a) Price = €801 (b) Price = €701
 CHAPTER 7 CONSUMERS, PRODUCEBS AND THE EFFICIENCY OF MARKETS 149

use both Price Raises Consumer Surplus

t this lv6y a Lower
WA nt to pay la S S for h e good c they b uy an d th at d lowe
are US n s SSUME S buye rS always
we
the well-b 1') shows d tvp tca downwa rds slop-
lule. \q1s the m b ette off an d m p rOVES ei n s igu re
F

A Ithoug h this de ma n d U rve ppears S om ewhat diffe rent n shape ro m the S tep- ke
At any n d CUTVC
prevrous two fig ure S th deas WE have St deve oped ap plv n eve rth less con-
u rves in OU
JU
/er, the n pa ne (a) co n SU mer SU rp US
th e a rea a bove the p fl ce nd be OW the dema nd U rve.
instance, S u rplus
q the a rea of riangle AB
ly for a gu of P
ro is now

ure
panel (a), 16u
r the dern6n6
rputed earliep

rea above the

iUmer SUrplus
Price
rmount is the Price A
A

surplus in a
buyers place
s willingness lnitial
Consumer consumer
'the demand surplus surplus
et for a good P1
c !i,jrli,l]lililji::.11 j:r li,)ji.ri l

P1 lrr j,iti:)rl! i,rj jjil: i,ll:;tl. ! t. l

B c

P2
D E
Demand
i -;t,ji,iijitl.|tl.-1, Demand
ilr iriliiirllr iir:r j1lllil.:ill
i

1e c0nsumer
Q1 Quantity 0 Q1 Q2 Quantity

(a) Consumer surplus at price P., (b) Consumer surplus at price P,

Now suppose that the prrce falls from P, to P, as shown in panel (b).The consumer surplus now equals
area ADE The increase in consumer surplus attributable to the lower price is the area BCFD.
This increase in consumer surplus is composed of two parts. First, those buyers who were already
i:r,tii lr .;,,; i: l
buying O, of the good at the higher price P, are better off because they now pay less. The increase in
consumer surplus of existing buyers is the reductron in the amount they pay; it equals the area of the rec-
tangle BCED. Second, some new buyers enter the market because they are now willing to buy the good at
the lower price. As a result, the quantity demanded in the market increases from O, to O' The consumer
surplus these newcomers receive is the area of the triangle CEE

What Does Gonsumer Surplus Measure?

and
Our goal in developing the concept of consumer surplus is to make normative judgements about the
desirability of market outcomes. lmagine that you are a policymaker trying to design a good economic
antity of
guitars system. Given the assumptions made in our model, consumer surplus would be important to consider
as it measures the net economic benefit in terms of surplus value that buyers receive from a good as
the buyers themselves perceive it. The demand curve is a representation of the value of the economic
benefit consumers get from consumption as measured by the price they have to pay to acquire the good;
150 PART 3 MARKETS, EFFICIENCY AND WELFARE

it assumes that they can accurately determine their preferences themselves, the opportunity cost of the
price they have to pay, and that their well-being is improved by more consumption. We assume that con-
sumers (mostly unconsciously) weigh up the value to them of buying a good. Psychologists have shown
that there are lots of different things going on when we make such choices apart from simply a rational
weighing up of the costs and benefits as we saw in our discussion of heuristics in Chapter 5. As a con-
sumer yourself, you will almost certainly be able to bring to mind instances where you have agonized ovgp
whether to buy something and if you were asked at that moment to describe your thinking you would no
doubt be weighing up a variety of factors. lf you are agonizing then you are operating right at this marginal
value - the maximum amount you are prepared to pay. For some reason, if the price you are being asked
to pay is slightly higher you decide not to buy - what you are berng asked to give up is not offset by the
value of the benefit you perceive you will get from purchasing the good.
You might also recall times when you have seen a good and snapped it up - you think to yourself you
have a bargain. You now have the tools to understand why you experience that feeling of getting a bargain -
it is because of the amount of consumer surplus you have gained from the purchase. Thus, consumer
surplus provides one way in which we can measure the value of the benefits to consumers of consumption.

Gonceiving of Price as a Bargaining Model Our discussion of markets so far has noted that price acts
as a signal to buyers and sellers.The actual purchasing decision by a consumer can be seen from the per-
spective of a bargaining model. Suppliers are offerlng goods to consumers at different prices and consum-
ers have to make decisions about whether the prices they are offered represent a net economic benefit
to them. This interaction between suppliers and consumers can be seen as a bargaining process, an
agreed outcome between two interested and competing economic agents.

bargaining process an agreed outcome between two interested and competing economic agents

Think of the times when you have Iooked at a price comparison website or been around almost every
shop in a mall only to return to the ltem you saw first, and bought that rtem. ln these cases consumers are
responding to the prices being offered by suppliers and making decisions based on the competing prices
available. Suppliers respond to the decisions made by consumers - if too few people buy their product then
they will be forced to take action to improve the product offering. lf consumers buy the product in sufficient
numbers to make it worthwhile for producers, then this implies that the supplier has some understanding
of the net benefit to consumers and can continue to work on finding ways to maximize this benefit at prices
consumers are wrlling to pay and at a cost which benefits the supplier.

ls Gonsumer Surplus Always a Good Measure of Economic Well-Being?

ln some circumstances, policymakers might choose not to care about consumer surplus because they do
not respect the preferences that drive buyer behaviour. For example, drug addicts are willing to pay a high
price for heroin. Yet we would not say that addicts get a large benefit from being able to buy heroin at a
low price (even though addicts might say they do). From the standpoint of society, willingness to pay, In
this instance, is not a good measure of the buyers' benefit, and consumer surplus is not a good measure
of economic well-being, because addicts are not lookrng after their long-term welfare.
The use of the word 'good' to describe products has not just arisen as a result of chance. A product described
as a 'good' implies that consumption of it confers positive benefits on consumers. Products like non-medicinal
drugs, tobacco and alcohol might be better described as 'bads' rather than 'goods' because they confer neg-
ative benefits to the consumer such as a deterioration in long-term physical and mental health - even though
many consumers of these goods would claim that they enjoy and therefore benefit from consuming them.
ln many markets, however, consumer surplus does reflect economic well-being. The underlying
assumption to thls is that we are presuming that buyers are rational when they make decisions and that
their preferences should be respected. ln this case, consumers are the best judges of how much benefit
they receive from the goods they buy. As we have seen, this assumption is open to some debate. ln addi-
tion it must be noted that an assumption made in the analysis so far is that one person's value of an extra
 CHAPTER 7 CONSUMERS, PRODUCERS AND THE EFFICIENCY OF MARKETS T51

:y cost of the
rme that coh
r'ave shovyi
ply a ration6;
5. As a s6n-
rgonized ovgp
rou would ns
this margin6l
being aske6
when you have used an auction website such as eBay' lf you won the
offset by the SEIF TEST Think about an occasion
how much consumer surplus did you gain? lf you dropped out of an auction, what were the factors
IrJor,jrprrined to pay a little
yourself yoLt *lirf, your decision? lf you just missed out on a bid, would you have been prepared
this tell you about your willingness pay? to
rg a bargain - morc in hindsight? What does
s, consumer
onsumption.

Gonsumer Surplus
at price acts @;'=
'rom the per- There is a very high chance that ifyou are reading this, you possess a smartphone and use
itto access
you do indeed own a smartphone, how valuable is it to you?
lnd consum- a variety of apps and internet services. lf
omic benefit Looking around the typical everyday environment, an onlooker might be tempted to say that smart-
process, an phones are extremely valuable to users given the number of people who walk around focused on what-

ever their smartphone is communicating to them. Many smartphone owners are likely to have paid
the device comes at no price at all on
a relatively low price for the device itself and in many cases,
the smartphone or pay a higher price for
agreeing a contract with a network provider. lf asked to pay for
a-r'ew uirsibn of a device, many users look elsewhere - in other words, the willingness
to pay for the
device is relatively low and it might be concluded from this that the consumer surplus of a smartphone
given the ubiquitous nature
itself is also relatively low. This seems to be a counter-intuitive conclusion
owners across the world).
rlmost every of the smartphone (it is estimated thatthere are some 2 billion smartphone
which
lsumers are 0ne reason may be because there are a relatively large number of substitutes in the market
main reason may be because the
reting prices tends to increase the price elasticity of demand for smartphones. The
the services it enables the user to
lroduct then device itself is simply a means of accessing what is really valuable, i.e.
applications, streaming, down-
in sufficient access. Communicating with friends through a wide range of social media
of value and
derstanding loading files, sharing images and accessing the lnternet may all be the'product'that is really
efit at prices provides considerable consumer surplus. Many people will think of these services as being'free'-the
payment of any subscription
use of Facebook, Twitter, lnstagram and Spotify for example, do not require
put on them by consumers,
or fee. lf the amount of time spent using these services is a measure of value
high. lndeed, two
it can be concluded that consumer surplus from the use of internet services relatively
is
estimate that it could be as
economists, Austan Goolsbee and Peter Klenory have looked at this issue and
astwo percentof full income (defined as incomefromwages andthevalue placed on leisuretime).
high
use they do
r pay a high
heroin at a
;s to pay, in
)d measure

:t described
rn-medicinal
confer neg-
rven though
rg them.
underlying
ns and that
uch benefit
rte. ln addi- What are the real benefits of using smartphones?
of an extra
15A PART 3 MARKETS, EFFICIENCY AND WELFARE

PRODUCER SURPTUS
We now consider the benefits sellers receive from participating in a market- As you will see, our analysis
of sellers' welfare is similar to our analysis of buyers' welfare.

Cost and the Willingness to Sell

lmagine that you own a house and need to get it painted externally. Four sellers of house painting ser-
vices, Millie, Georgia, Julie and Nana are each willing to do the work for you if the price is right. You decide
to take bids from the four painters and auction off the job to the painter who will do the work for the lowest
price (assuming the quality each painter provides is the same).
Each painter is willing to take the job if the price she would receive exceeds her cost of doing the
work. Here the term cost should be interpreted as the painter's opportunity cost: it includes the paint-
er's out-of-pocket expenses (for palnt, brushes and so on) as well as the value that the painter places
on her own time. Table 7.2 shows each painter's cost. Because a painter's cost is the lowest price she
would accept for her work, cost is a measure of her willingness to sell her services. Each painter would
be eager to sell her services at a price greater than her cost. would ref use to sell her services at a price
less than her cost, and would be indifferent about selling her services at a price exactly equal to her
cost.

cost the value of everything a seller must give up to produce a good

The Gosts of Four Possible Sellers

Seller Cost (€)

Millie 900
Julie 800
Georgia 600
Nana 500

When you take bids from the painters, the price might start off high, but it quickly falls as the painters
compete for the job. Once Nana has bid slightly less than €600, she is the sole remaining bidder. Nana is
willing to do the job for this price, because her cost is only €500. Millie, Georgia and Julie are unwilling to
do the job for less than €600. What benefit does Nana receive from getting the job? Because she is willing
to do the work for €500 but gets €599.99 for doing it, we say that she receives producer surplus of €99.99.
Producer surplus is the amount a seller is paid minus the cost of production. Producer surplus measures
the benefit to sellers of participating in a market.

producer surplus the amount a seller is paid for a good minus the seller's cost

Now suppose that you have two houses that need painting. Again, you auction off the jobs to the four
painters. To keep things simple. let's assume that no painter is able to paint both houses and that you will
pay the same amount to paint each house. Therefore, the price falls until two painters are left.
ln this case, the bidding stops when Georgia and Nana each offer to do the job for a price slightly
less than €800 (€799.99). At this price, Georgia and Nana are willing to do the work, and Millie and
Julie are not willing to bid a lower price. At a price of €799.99, Nana receives producer surplus of
€299.99, and Georgia receives producer surplus of €199.99.The total producer surplus in the market
is €499.98.
 CHAPTER 7 CONSUMERS, PRODUCERS AND THE EFFICIENCY OF MABKETS 153

Using
the Supply Gurve to Measure Producer Surplus
rirra beOiflby using the costs of the four painters to find the supply schedule for painting services, The
J"ir" in Figure 7.4 shows the supply schedule that corresponds to the costs in Table 7.2. lf lhe price is
, our analysis
llow €b00, none of the four painters is willing to do the job, so the quantity supplied is zero. lf the price
i""n"t*r"n €500 and €599.99, only Nana is willing to do the job, so the quantity supplied is 1. lf the price
job, so the quantity supplied is 2,
il [rr*""n €600 and €799.99, Nana and Georgia are willing to do the
,o on. Thus, the supply schedule is derived from the costs of the four painters.
u-nd
painting seF
rt. You decide
or the lowest
fte Supply Schedule and the Supply Gurve Price of
of doing the The table shows the supply schedule for
the sellers in house
Supply
painting (€)
es the paint- Table 7.2. The graph shows the corresponding supply
tinter places curye. Note that the height of the supply curve reflects i
900 i.,!i!lr'", ,,.r, ;

)st price she sellers'costs.

:iir : , { r.l
800 :i
ainter would
;es at a price Ouantity
600 ir r:i ii ii.'
Pdce Sellers supplied
equal to her 500 r,, r .i r.ir i ,

€901 or more Millie, Julie, Georgia, 4

Nana
€801- €900 Julie, Georgia, Nana J

€601 - €800 Georgia, Nana z

€500 - €600 Nana 1

Less than €500 None . 0

0 1 234 Quantity of
houses painted

The graph in Figure 7.4 shows the supply curve that corresponds to this supply schedule. Note that the
height of the supply curve is related to the sellers' costs. At any quantity, the price given by the supply
curve shows the cost oI the marginat seller, the seller who would leave the market first if the price were
any lower. At a quantity of 4 houses, for instance, the supply curve has a height of €900, the cost that
the painters Millie (the marginal seller) incurs to provide her painting services. At a quantity of 3 houses, the supply
lder. Nana is curve has a height of €800, the cost that Julie (who is now the marginal seller) incurs.
r unwilling to Because the supply curve reflects sellers' costs, we can use it to measure producer surplus. Figure 7.5
she is willing uses the supply curve to compute producer surplus in our example. ln panel (a) we assume that the price
is €599.99. ln this case, the quantity supplied is 1. Note that the area below the price and above the supply
us of €99.99.
us measures curve equals €99.99. This is Nana's producer surplus.
Panel (b) of Figure 75 shows producer surplus at a price of €799.99. ln this case, the area below the
price and above the supply curve equals the total area of the two rectangles. This area equals €499.98, the
producer surplus wercomputed earlier for Georgia and Nana when two houses needed painting.
The lesson from this example applies to all supply curves: the area below the price and above the supply
curve measures the producer surplus in a market. The logic is straightforward: the height of the supply curve
measures sellers' costs, and the difference between the price and the cost of production is each seller's pro-
ducer surplus. When multiplied by the quantity, the total area is the sum of the producer surplus of all sellers.
rs to the four
that you will
t.
How a Higher Price Raises Producer Surplus
lrice slightly
rd Millie and The concept of producer surplus offers an insight to the increase in well-being of a producer in response
rr surplus of to a higher price.
r the market Figure 7.6 shows a typical upwards sloping supply curve. Even though this supply curve differs in shape
from the step-like supply curves in the previous figure, we measure producer surplus in the same way:
154 PABT 3 MARKETS, EFFICIENCY AND WELFARE

Measuring Producer Surplus with the Supply Gurve

(b) the price of the good is €799.99 and the
ln panel (a) the p1ce of the good is €599.99 and the producer surplus is €99.99. ln panel
producer surplus is €499.99.

Price of house Price of house

painting (€) Supply
Supply painting (c)

899.99 899.99
799.99 799.99

599.99 599.99
s00 500

hrr:i.t;

1 2 3 4 Quantityof 1 2 3 4 Quantityot
houses painted houses painted
(a) Price = €599.99 (b) Price = €799.99

FIGURE 7.6
How the Priee Aflects Producer Surplus
ln panel (a) the price is P,, the quantity denanded is 0., and producer surplus equals the area of the triangle ABC. When the price rises
fron P, to Pu as in panel (b| the quantity supplied rises fron 0, to 0rand the producer surplus rises to the area of the triangle ADF. The
increase in producer surplus (area BCFD) occurs in part because existing producers now receive more (area BCED) and in part because
new producers enter the market at the higher price (area CEF).

Price Price
Supply Supply

D
P2
F

B B
P1 P1
c c
Producer lnitial
surplus producer
surplus

A A

0 Q1 Quantity 0 Ql Q2 Quantity
(a) Producer surplus at price P, (b) Producer surplus at price P,

producer surplus is the area below the price and above the supply curve. ln panel (a), the price is p, and
producer surplus is the area of triangle ABC.
Panel (b) shows what happens when the price rises from P,roPr. Producer surplus now equals area
ADE This increase in producer surplus has two parts. First, those sellers who were already selling O., of
the good at the lower price P, are better off because they now get more producer surplus for what they
sell, The increase in producer surplus for existing sellers equals the area of the rectangle BCED. Second,
td the

surplus the same as profit? Explain

TEST ls producer

ce rises
ADE The
ecause

Supply

ffi
Quantity

isP,a nd

Jals area
ng 01 of
'hat they
Second,
156 PART 3 MARKETS, EFFICIENCY AND WELFARE

therefore, the value of the additional unit to buyers is the same as the additional cost to producers. We can
look at the consumer and producer surplus at equilibrium and add these together to get a m".srr" of 1lu
total surplus. lf the consumer surplus is a measure of the consumer's well-being and producer surplus ii
a measure of the seller's well-being, then total surplus can be used as a measure of society's
well-being. We can summarize this as: ""onornil

Total surplus = Value to buyers - Cost to sellers

total surplus the total value to buyers of the goods, as measured by their willingness t0 pay, minus the cost to sellers of
providing those goods

lf an allocation of resources maximizes total surplus, we say that the allocation exhibits efficiency. lf an
allocation is not efficient, then some of the gains from trade among buyers and sellers are not being realized.
For example, an allocation is inefficient if a good is not being produced by the sellers with lowest cost. ln this
case, moving production from a high-cost producer to a low-cost producer will lower the total cost to sellers
and raise total surplus. Similarly, an allocation is inefficient if a good is not being consumed by the buyers
who value it most highly. ln this case, moving consumption of the good from a buyer with a low valuation to
a buyer with a high valuation will raise total surplus. ln Chapter 1, we defined efficiency as'the property of
society getting the most it can from its scarce resources'. Now that we have the concept of total surplus, we
can be more precise about what we mean by 'getting the most it can'. ln this context, society will be getting
the most it can from its scarce resources if it allocates them so as to maximize total surplus.

efficiencythe property of a resource allocatiQn of maximizing the total surplus received by all members of society

Figure7.7 shows consumer and producer surplus when a market reaches the equilibrium of supply and
demand. Recall that consumer surplus equals the area above the price and under the demand curve and
producer surplus equals the area below the price and above the supply curve.Thus, the total area between
the supply and demand curves up to the point of equilibrium represents the total surplus in this market.

@ Price
Consumer and Producer Surplus at the A
Market Equilibrium
Total surplus - the sum of consumer and D
producer surplus - is the area between the Supply
supply and demand curves up t0 the equilibriun
quantity.
Consumer
surplus

Equilibrium
pflce
Producer
, surplus

Demand
B

0 Equilibrium Quantity
quantity
 CHAPTER 7 CONSUMERS, PRODUCERS AND THE EFFICIENCY OF MARKETS 15?

lers. we
rasure of
ie SU rplus
.S
econ

sellers of

ciency. lf 6x makes at least one economic agent better off without

harming another economic
pareto improvement when an action
Irng realizefl,
agent
cost. ln this
lst to sellers
I the buyerg
valuation to luating the Market Equilibrium
po nt whe re he ma rket S n equr ibnu m a n alloca-
property of h ave noted that total SU rp US IS maxl m ized at the p
maxi mrzrng utility an d producers maxi m ztn s profits and roduci
ng
surplus, we of te sources wh ere CO nsu mers are the wel l-be ng
possib A to rea locate resources n a ny other way to tn crease
ill be getting m n m m ave ra ge cost. S rt wou resu It from ny
WO rds, are th ere Pa reto rmprove ments that
d a
consu me rS a nd produ cers n othe
S?
such resource d ocatr on
The pnce dete rm ines.wh ich b uyers an d
sellers pa rtic pate tn th e market. Those buye rS who VA lue the
ly good more rh a n the price (rep resented by th e
segm ent AE on th e dema nd cu rve tn Fig ure 1. 7\ choose
to buy th e good; those buye rS who VA ue
it CSS than the price (rep resented by th e segme nt E B) do not.
S up plv
SimilarlY thos e sellers whos cos tS a
re ESS tha n the pnce (re prese n te d by the segm ent CE on the
greater th n the price (re pre-
good those SE ers whose costs re
supply and curve) choose to prod U ce an d sell the
I curve and sented by the segment ED) do not
based on the assumptions of the model:
>a between These observations lead to two insights about market outcomes
is market. who value them most highly' as measured by
1. Free markets allocate the supply of goods to the buyers
their willingness to PaY
produce them at least cost
2. Freemarkets allocate the demand for goods to the sellers who can
economic well-being cannot be
Thus, given the quantity produced and sold in market equilibrium'
allocations'
increased by consumers orproducers changing their respective

We can also identrfy a third insight about market outcomes:

sum of consumer and producer surplus
3. Free markets produce the quantity of goods that maximizes the
To see why this is true, consider Figure 78. Recall that the
demand curve reflects the value to buyers and
the equilrbrium level, the value to buyers
that the supply curve reflects the cost to sellers. At quantities below
quantity raises total surplus, and it continues to do so
exceeds the cost to sbllers. ln this region, increasing the
until the quantrty reaches the equilibrLm level.
gey;nO the equilibrium quantity, however, the value to buyers is
quantity would, therefore' lower total surplus'
less than the cost to sellers. Producrng more than ihe equilibrium
equilibrium outcome is an efficient alloca-
These three insights about market outcomes tell us that the
tron of resources given the assumptions of the model'
This conclusion explains why some economists
actlvity'
advocate free markets as a preferred way to organize economic

from chapter 5 and on producer equilibrium from

SELF TEST Look back at the section on consumer optimum
these equilibrium points and market equilibrium in
Quantity chapter 6. How might you explain the relationship benrueen
terms of economic efficiencY?
158 PART 3 MARKETS, EFFICIENCY AND WELFARE

The Efficiency of the Equilibrium Ouantity Price

At quantities less than the equilibriun quantity, the value to Suppty
buyers exceeds the clst t0 sellers. At quantities greater than
the equilibrium quantity, the clst to sellers exceeds the value
to buyers. Therefore, the market equilibriun naximizes the
sun of producer and consuner surplus.
Value Cost
to to
buyers sellers

Cost Value
to to
Demand
sellers buyers

0 Equilibrium Quantity
qu

l{.:/ l:rluf),{:,!irt llr j 't?,1lrri. :lor Iirriil{..tr.irr iiij

1!t;l:riii(.li iliil!rl irl f;.iiJ :lr 'li;l:.;i, j tiiij:.rii:l i,l{rl:}, i(.1

ilot r:.il1i::rir.; . lrjli.rj i:r

Efficiency and Equity

Much of this chapter has focused on efficiency. lt is not surprising that there is a great deal of focus on
efficiency in economics because it is something that can be measured and is quantifiable. Efficiency is
a positive concept in that it can be stated what is an efficient allocation.This does not, however, tell us
anything about whether the efficient allocation is desirable or not.
We also have to consider whether an allocation is fair and this is a normative concept. One way of looking
at fairness in economic allocations is to consider equity - the property of distributing economic prosperity
fairly among the members of society. ln essence, the gains from trade in a market are like a cake to be dis-
tributed among the market participants. The question of eff icrency is whether the cake is as big as possible.
The question of equity is whether the cake is divided fairly and, as noted in Chapter 1, can involve trade-offs
in decision-making. Evaluating the equity of a market outcome is more difficult than evaluating the efficiency.
Whereas efficiency is an objective goal that can be judged on strictly positive grounds, equity involves nor-
mative judgements that go beyond economlcs and enter into the realm of political philosophy.
One of the problems with the analysis we have presented is an assumption that economic agents are all
similar - that consumers and producers are a heterogeneous group. Clearly this is not the case. One of the
most important things economists have to consider is the different way that people with different income
endowments and economic power behave. The marginal utility gained from spending an extra unit of income
for a very poor person is likely to be very different to that of a rich person, for example. Looking at well-being
simply from the perspective of adding up the consumer and producer surpluses masks more complex issues.
Some economists point to the collective utility of society which is reflected by consumer and pro-
ducer surplus in terms of a social welfare function. Social welfare functions attempt to take into
account the fact that the marginal utilities of individual households are not all the same and indeed that
their preferences are also different.This is based on the assumption that welfare is an ordinal function,
i.e. that consumers can rank preferences. However, it is also assumed that households operate with
imperfect knowledge. Decisions in the market may be made by those who have some power which can
distort market outcomes. For example, the spending power of the rich or those with political influence
can mean that market outcomes are disproportionately skewed. The outcome may be efficient but it is
not necessarily fair.
 CHAPTER 7 CONSUMEBS, PRODUCERS AND THE EFFICIENCY OF IVARKETS 159

function the collective utility of society which is reflected by consumer and producer surplus
social welfare
Suppty

ta ke nto acco U nt, therefo re, that dlffe re nt stake h o td rS have d fferent perspect tves ba ed a
We m ust
belief system J o n what good' fo ety a whol On e exa m ple of th ese
persona nd sha red
SOC
relat to tn com WO uld you rat h er
nt persp ectrve S wh ich a re referred to states,
socta is n ton
of it stri buted e that d S ma
asocietY h at focuse d U n ra IS ng tota ncome regardle SS h OW WAS d
r of people owned a considerable portion of this income, or a social state
where income was more

even ly
dlstributed among its crtizens?
n the next chapte rS WC begi n to loo k a how th ese ISS UES td ke on m re relevan ce when g over n m e nts
mar kets by affecti ng market o utco mes to tm prove them Cle rly, gove rnm e n says
get nvo lve d n
ng policies to ry and mprove m rket U U tcom ES WE a re in the real m of n o rmative econ o m lcs
it ts adoPtt
an d looki ng
at what should b e ma rket o u tcom U rat h tha n wha
A /s.

Th c chapte h AS ntro du ced the ba S tools of we lfa re eco nom ics cons u m e an d prod ucer ur-
temand dl ke mod e ba sed on
d n d u 5 ed them to eva luate the me n ng of eff ic en cy n the fre e m rts
pl us
n his model m ar ket U U b flu m max
q m ze c th tot ben efi tS to b uye rS
assu m pti NS We sh owed that
luantity sellers. A m ket outcom e may be dentif i E d a eff ic ent but it do ES
c not fo low that this pa rtic ula
and
outcome is fair.

IN THE NEWS to
he
D>

focus on
Well-Being
ciency is Wetfare economics has been a sub-topic in the discipline since the 19th century but exactly
;r, tell us how we measure welt-being is something that has been repeatedly visited and refined over
the years. ln the UK, the ONS estabtished the Measuring NationalWell-being programme in
,f looking 2010 and in 2015 pubtished the third annual repoft on Life in the UK (see http://wvvw'ons'gov.
rosperity u l</o n s/dcp 1 7 1 766-3980 59. pdf ).
o be dis-
:ossible.
-ade-offs
Measuring NationalWell-being: Life in the UK,2015
lf iciency.
lves nor- The Financial Crisis of 2007-9 and subsequent recession hit many businesses and individuals in the UK. Real wages
had been falling for some years and unemployment had risen as the economy shrank. By 2015, however, there were
ts are all signs that the economy was recovering and real wages began to increase, unemployment fell and economic
groMh
e of the was stronger. The 2015 report on annual well-being in the UK continued to look at measures of well-being -which
income included health, where people live, whatthey do, and their relationships - and to report on howthese measures have
income changed over time. ln'total 43 measures were reviewed including such things as how we use our leisure time and
-"ll-being how safe we feel walking alone after dark.
r issues. The 2015 publication noted that compared to the last report, l4 of these measures had improved, l8 had shown no
rnd pro- overall change, two had got worse and nine were not sublect to assessment for the 2015 report' Over a three-year
rke into period, 12 measures had improved, ten showed no change, eight had got worse and 13 were not assessed. Measures
red that not assessed may be because there was insufficient data to make a comparison or where there was no clarity on
rnction, the direction of change.
te with 0ne of the importantfindings inthe reportwasthatthe overall economic'cake'has increased butthatthe dis-
rich can posable income generated was not increasing in the same way. Despite this, more people reported feeling positive
f luence about life compared lo2012,which given the improvement in the economy is perhaps not surprising. Life expectancy
lut it is
lContinuedl
160 PART 3 MARKETS, EFFICIENCY AND WELFARE

is increasing but almost a third of

people in the survey expressed
concerns about health with almost
20 per cent reporting a long-terrn
illness or disability which affected
their lives. Those on higher incomes
tend to make better lifestyle choices
such as not smoking, eating a health-
ier diet and taking exercise. 0verall,
however, over half ofthose surveyed
{almost 52 per cent} did not engage in
'moderate intensity sport'for 30 min-
utes or more on a regular basis. The
number of people living in relative
povefty (defined where household
income is less than 60 per cent of
median income after housing costs)
Healthy lifestyte choices can improve overall well-being but low income families
has not changed since 2010.
may face significant disadvantages in making appropriate choices.

Auestions
t Gonsumer surplus and producer surplus can be used as a measule of well-being but given the article, how
comprehensive and valuable a measure do you think this is?
2 Gonsumer and producer surplus provide measures which are positive; the measures reported by the ONS ate
gathered through a survey and in some cases reports people s self-perceptions with regard to some of the meas-
ures used. Which do you think an economist should place more reliance on and why?
3 What explanations might there be for the observation by the report that overall production in the UK has risen
but disposable incomes have not increased in the same way?
'completely satis-
4 Gonsider the QNS' approach of asking people to respond to questions through a scale, lrom
lied'to 'completely dissatisfied'. What sort of scale is this and why might it present problems in interpreting
people's responses?
5 Do you think economists should locus on measuring efficiency, which is a positive concept, and pay less aften-
tion to equity, which is a normative concept? How might research like the 0NS'Life in the UK,20l5'survey help
in the analysis ol well-being?
Source: http://webarchive.nationalarchives.gov.uk/20160105160709/http://www.ons.gov.uUons/dcp171766-398059.pdf

SUMMARY I
o Consumer surplus equals buyers' willingness to pay for a good minus the amount they actually pay for it, and it
measuresthe benefit buyers getfrom participating in a market. Consumer surplus can be computed byfinding the
area belowthe demand curve and above the price.
o Producer surplus equals the amount sellers receive for their goods minus their costs of production. and it meas-
ures the benefit sellers getfrom participating in a market. Producer surplus can be computed byfinding the area
below the price and above the supply curve.
r 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'
o The equilibrium of supply and demand maximizes the sum of consumer and producer surplus. That is, the invisible
hand of the marketplace leads buyers and sellers to allocate resources efficiently.
 CHAPTER 7 CONSUMERS, PRODUCERS AND THE EFFICIENCY OF MARKETS 161

ONS FOR REVIEW

a third of
the term 'allocative efficiency'?
expressed is meant by
uith almost is welfare economics?
long-te16 rs' willi ngness to pay, c o n sumer su rpl u S and th e d e ma n d c u rve a re re ated.
aln how buye
h affected how sel ers' costs, p r0 d u cer sur pl u S and the s
U p p ly curve re re ated.
ai n
er incomes n d c o n SU mer su rpl us at th e ma rket eq uili bri m
su p p ly-and -dema n d di ra m, S h owrng prod u ce
te
rle choices
rg ahealth- tseffi c e n cy n d h OW m ght WC m e a sure it?
;e. Overall. su pPlY- a nd- d mand d ta m y0u drew fo 0u e stion 5, assume th at the demand S h ifts to th e ri ht as resu It of
Using the of th
e surveyed rn ncomes 0 n th e d ra m, show h OW c on sumer sur pl US and pro d u c e s u rp lu S c h anges AS a re SU It
n inc re ase pend
,]
the S m e What would the outc 0m
? de 0n
t engage in
sh ift in d m a nd. ls total SU rp U rncre as e d, d ecreas e d 0 does it stay
for 30 min- a Pareto efficient outcome?
What is meant by
basis. The to be concerned
efficiency classed as positive? What are the normative issues we might want
in relative Why are issues relating to
household with?
Festival go on sale, the demand exceeds supply by a considerable margin. Many
er cent of When the tickets for the Glastonbury
neoole who are willing t0 pay the price for tickets are excluded
from the market. Explain how charging a higher price
;ing costs)
efficient market allocation. would this also be an equitable
0. irr rir-nri, i.i,he Glasionbury Festival would lead to a more

market allocation? ExPlain.

ticle, how
PROBLEMS AND APPTICATIONS
happiness and satisfaction with life, how would
e ONS are I How would you define the concept oI welfare? lf well-being is about
the meas- y.u, as an economist, go abouttrying to define and quantify happiness and satisfaction with life? ls it possible to do so?
An early freeze in Noimandy ruins half of the apple harvest. What happens
to consumer surplus in the market for
2
lllustrate your answers with diagrams'
has risen apples? What happens to consumer surplus in the market for cider?

Suppose the demand for French bread rises. What happens to

producer surplus in the market for French bread? What
tely satis-
3
happens to producer surplus in the market for flour? lllustrate your answers
with diagrams.
terpreting
4ltisahotday,andGi.interisthirsty.Hereisthevalue,inmoneyterms,heplacesonabottleofwater:
ess atten-
rrvey help Value of first bottle €7
Value of second boftle €5
Value ofthird boftle €3
Value offourth boftle €1

a. From this information, derive Gi.inter's demand schedule. Graph his demand
curve for bottled water.
b. lfthepriceofabottleofwateris€4.howmanybottlesdoesG[interbuy?HowmuchconsumersurplusdoesGiinter
get from his purchases? Show Giinter's consumer surplus on your graph'
surplus change? Show
c. lf the price falls to €2, how does quantity demanded change? How does Giinter's consumer
these changes ofi Your graPh.
pumping small amounts, the cost
'for it, and it 5 Maria owns a water pump. Because pumping large amounts of water is harder than
pumps more. Here is the cost she incurs to produce each bottle of water:
ry finding the of producing a bottle of water rises as she

Cost of first bottle €1

and it meas-
Cost of second bottle €3
ling the area
Cost of third bottle €5

Cost of fourth bottle €7

be efficient.
a. From this information, derive Maria's supply schedule. Graph her supply curve for bottled water'
producer surplus
the invisible b. lf the price of a bottle of water is €4, how many bottles does Maria produce and sell? How much
your graph.
does Maria get from these sales? Show Maria's producer surplus on
162 PART 3 MARKETS, EFFICIENCY AND WELFARE

c. lfthepricerisesto€6,howdoesquantitysuppliedchange?HowdoesMaria'sproducersurpluschange?Showthesq
changes in your graph.

6 Consider a market in which Giinter from Problem 4 is the buyer and Maria from Problem 5 is the seller.

a. Use Maria's supply schedule and Gtinter's demand schedule to find the quantity supplied and quantity demanded q1

prices of €2, €4 and €6. Which of these prices brings supply and demand into equilibrium?
b. What are consumer surplus, producer surplus and total surplus in this equilibrium?
c. lfMariaproducedandGijnterconsumedonefewerbottleofwater,whatwouldhappent0total surplus?
d. lfMariaproducedandGiinterconsumedoneadditional bottleofwater,whatwouldhappentototal surplus?

7 Why might we want to think about market price as the outcome of a bargaining model?

I The cost of producing smartphones has fallen overthe pastfewyears

a. Use a supply-and-demand diagram to show the effect of falling production costs on the price and quantity of
smartphones sold.
b. ln your diagram, show what happens to consumer surplus and producer surplus.
c. Suppose the supply of smartphones is very price elastic. Who benefits most from falling production costs -
consumers or producers of smaftphones?

9 Four consumers are willing to pay the following amounts for haircuts:
Hans: Juan; Peter: Marcel:

€7 €2 €8 €5

There are four haircutting businesses with the following costs:

Firm A: Firm B: Firm C: Firm D:

€3 €6 €4 €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?

10 Suppose a technological advance reduces the cost of making tablet devices.

a. Useasupplyanddemanddiagramtoshowwhathappenstoprice,quantity,consumersurplusandproducersurplus
in the market for tablet devices.
b. Tablet devices and laptops are substitutes. Use a supply-and-demand diagram to show what happens to price,
quantity, consumer surplus and producer surplus in the marketfor laptops. Should laptop producers be happy or sad
about the technological advance in tablet devices?
c. Tablet devices and apps are complements. Use a supply-and-demand diagram to show what happens to price,
quantity, consumer surplus and producer surplus in the market for apps. Should app producers be happy or sad
about the technological advance in tablet devices?