Session 6 - Chp6 Consumers, Producers, and The Efficiency of Markets

7
6
Consumers, Producers,
and the Efficiency of Markets
PowerPoint Slides prepared by:

Andreea CHIRITESCU
Eastern Illinois University
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Consumer Surplus
• Welfare economics
– The study of how the allocation of
resources affects economic well-being
• Benefits that buyers and sellers receive from
engaging in market transactions
• How society can make these benefits as large
as possible
• The equilibrium of supply and demand
maximizes the total benefits received by all
buyers and sellers combined
Consumer Surplus
• Willingness to pay
– Maximum amount that a buyer will pay for
a good
– How much that buyer values the good
• Consumer surplus
– Amount a buyer is willing to pay for a good
minus amount the buyer actually pays for
it
– Willingness to pay minus price paid
Consumer Surplus
• Exercise
The only four consumers in a market have the following willingness
to pay for a good:
Buyer Willingness to Pay
Ming-la $45
Wilbur $35
Quilana $25
Carlos $15
If the price is $30, then consumer surplus in the market is

a. $20, and Wilbur and Ming-la purchase the good.
b. $20, and Carlos and Quilana purchase the good.
c. $30, and Wilbur and Ming-la purchase the good.
d. $30, and Carlos and Quilana purchase the good.
Consumer Surplus
• Exercise
The only four consumers in a market have the following willingness
to pay for a good:
Buyer Willingness to Pay
Ming-la $45
Wilbur $35
Quilana $25
Carlos $15
If there is only one unit of the good and if the buyers bid against each
other for the right to purchase it, then the consumer surplus will be
a. $0 or slightly more.
b. $10 or slightly less.
c. $30 or slightly more.
d. $45 or slightly less.
Consumer Surplus
– Measures the benefit buyers receive from
participating in a market
– Closely related to the demand curve
• Demand schedule
– Derived from the willingness to pay of the
possible buyers
Consumer Surplus
• At any quantity, the price given by the
demand curve
– Shows the willingness to pay of the
marginal buyer
• The buyer who would leave the market first if
the price were any higher
• Consumer surplus in a market
– Area below the demand curve and above
the price
Figure 3
How Price Affects Consumer Surplus
(a) Consumer Surplus at Price P1
Price
A
Consumer
surplus C
P1
B
Demand
0 Q1 Quantity
In panel (a), the price is P1, the quantity demanded is Q1, and consumer surplus equals the area
of the triangle ABC. When the price falls from P1 to P2, as in panel (b), the quantity demanded
rises from Q1 to Q2, and the consumer surplus rises to the area of the triangle ADF. The increase
in consumer surplus (area BCFD) occurs in part because existing consumers now pay less (area
BCED) and in part because new consumers enter the market at the lower price (area CEF).
Consumer Surplus
• A lower price raises consumer surplus
1. Existing buyers: increase in consumer
surplus
• Buyers who were already buying the good at
the higher price are better off because they
now pay less
2. New buyers enter the market: increase in
consumer surplus
• Willing to buy the good at the lower price
Figure 3
How Price Affects Consumer Surplus
(a) Consumer Surplus at Price P1 (b) Consumer Surplus at Price P2
Price Price
A A Additional consumer
surplus to initial consumers
Initial Consumer surplus

Consumer consumer
surplus C surplus C to new consumers
P1 P1
B B
F
P2
Demand D E Demand
0 Q1 Quantity 0 Q1 Q2 Quantity
In panel (a), the price is P1, the quantity demanded is Q1, and consumer surplus equals the area
of the triangle ABC. When the price falls from P1 to P2, as in panel (b), the quantity demanded
rises from Q1 to Q2, and the consumer surplus rises to the area of the triangle ADF. The increase
in consumer surplus (area BCFD) occurs in part because existing consumers now pay less (area
BCED) and in part because new consumers enter the market at the lower price (area CEF).
Consumer Surplus
• Exercise
A drought in California destroys many red grapes. As a result of
the drought, the consumer surplus in the market for red grapes
a. increases, and the consumer surplus in the market for red
wine increases.
b. increases, and the consumer surplus in the market for red
wine decreases.
c. decreases, and the consumer surplus in the market for red
wine increases.
d. decreases, and the consumer surplus in the market for red
wine decreases.
Consumer Surplus
– Benefit that buyers receive from a good
• As the buyers themselves perceive it
– Good measure of economic well-being
• Next: Producer surplus
Producer Surplus
• Cost (or, willingness to sell)
– Value of everything a seller must give up
to produce a good
– Measure of willingness to sell
• Producer surplus
– Amount a seller is paid for a good minus
the seller’s cost of providing it
– Price received minus willingness to sell
Producer Surplus
• Producer surplus
– Closely related to the supply curve:
• At any quantity
– Price given by the supply curve shows the
cost of the marginal seller
• Seller who would leave the market first if the
price were any lower
Producer Surplus
• Producer surplus in a market
– Area below the price and above the
supply curve
Figure 6
How Price Affects Producer Surplus
(a) Producer Surplus At Price P1 (b) Producer Surplus At Price P2
Price Price Additional producer

Supply surplus to initial producers Supply
D E F
P2
B B
P1 P1
C Initial C Producer surplus
Producer producer
surplus to new producers
surplus
A A
0 Q1 Quantity 0 Q1 Q2 Quantity
In panel (a), the price is P1, the quantity supplied is Q1, and producer surplus equals the area of
the triangle ABC. When the price rises from P1 to P2, as in panel (b), the quantity supplied rises
from Q1 to Q2, and 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).
Producer Surplus
• A higher price raises producer surplus
1. Existing sellers: increase in producer
surplus
• Sellers who were already selling the good at
the lower price are better off because they
now get more for what they sell
2. New sellers enter the market: increase in
producer surplus
• Willing to produce the good at the higher
price
Producer Surplus
• Exercise
If the demand for a good or service decreases, producer
surplus
a. increases.
b. decreases.
c. remains the same.
d. may increase, decrease, or remain the same.
Market Efficiency
• Total surplus = Consumer surplus +
Producer surplus
• Consumer surplus = Value to buyers –
Amount paid by buyers
• Producer surplus = Amount received by
sellers – Cost to sellers
• Amount paid by buyers = Amount received by
sellers
• Total surplus = Value to buyers – Cost to
sellers
Figure 7
Consumer and Producer Surplus in the Market Equilibrium
Price
A Supply
D
Consumer
Equilibrium surplus
E
price Producer
surplus
B
Demand
C
0 Equilibrium Quantity
quantity
Total surplus—the sum of consumer and producer surplus—is the area between the
supply and demand curves up to the equilibrium quantity
Market Efficiency
• Efficiency
– Property of a resource allocation
– Maximizing the total surplus received by
all members of society
• One type of efficiency:
– Pareto Efficiency
Market Efficiency
• Pareto Efficiency
– The allocation where no one can be made
better off without making someone else
worse off
• Pareto Improvement
– An alternative allocation that makes
someone better off without hurting anyone
else
– A Pareto Efficient allocation has no Pareto
Improvements
Market Efficiency
• The market equilibrium (usually) yields an
efficient allocation.
Figure 7
Price
A Supply
B
Demand
C
0 Quantity
If price is above the equilibrium price, a lower-than-equilibrium quantity is produced
and consumed. Not efficient, because we can sell one more unit to the next
consumer at a slightly lower price. And total surplus will go up.
Figure 7
Price
A Supply
Consumer
surplus D
Producer
E
surplus
B
Demand
C
0 Quantity
If price is above the equilibrium price, a lower-than-equilibrium quantity is produced
and consumed. Not efficient, because we can sell one more unit to the next
consumer at a slightly lower price. And total surplus will go up.
Figure 7
Price
A Supply
B
Demand
C
0 Quantity
When price is below equilibrium price, what happens? Is this efficient?
Figure 7
Price
A Supply
Consumer
E
surplus
Producer
surplus B
Demand
C
0 Quantity
Not efficient. With a price this low, the firm is only willing to produce a quantity lower
than the efficient quantity. If the firm produces an extra unit and sells it to the next
consumer at a slightly higher price, there will be an increase in surplus.
Market Efficiency
• Exercise
At equilibrium, consumer
surplus, produce surplus,
and total surplus are 44
a. $12; $24; $36
b. $24; $12; $36
c. $36; $72; $108.
d. $72; $36; $108.
Market Efficiency
• Exercise
If 4 units of the good are
produced and sold, then
a. the cost to sellers exceeds
the value to buyers.
b. producer surplus is
maximized.
c. total surplus is minimized.
d. the allocation of resources
is inefficient.
Market Efficiency
• Exercise
If 10 units of the good are
produced, then
a. the marginal cost to
sellers exceeds the
marginal value to buyers.
b. producer surplus is
maximized.
c. total surplus is minimized.
d. the marginal value to
buyers exceeds the
marginal cost to sellers.
Market Efficiency
• Outcomes of free markets (in equilibrium):
1. Free markets allocate the supply of
goods to the buyers who value them
most highly
• Measured by their willingness to pay
2. Free markets allocate the demand for
goods to the sellers who can produce
them at the least cost
Market Efficiency
• Outcomes of free markets (in equilibrium):
3. Free markets produce the quantity of
goods that maximizes the sum of
consumer and producer surplus
‒‒‒ Adam Smith’s “invisible hand”
Market Efficiency & Failure
• Forces of supply and demand
– Allocate resources efficiently
• Several assumptions about how markets
work
1. Markets are perfectly competitive
2. Outcome in a market matters only to the

buyers and sellers in that market
• Forces of supply and demand
– Allocate resources efficiently
• Several assumptions about how markets
work But sometimes they do not hold
1. Markets are perfectly competitive
*Market power
2. Outcome in a market matters only to the
buyers and sellers in that market
*Externalities
• Market Failure
– Market power
• Monopoly
– Externality
• Positive externalities
• Negative externalities
– Government policies can potentially
remedy these market failures
* Some other times, government intervention itself
could distort the market

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If the price is $30, then consumer surplus in the market is

Initial Consumer surplus

• Next: Producer surplus

Price Price Additional producer

When price is below equilibrium price, what happens? Is this efficient?

‒‒‒ Adam Smith’s “invisible hand”

2. Outcome in a market matters only to the

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