Introduction To Economics: Topic 4

Introduction to Economics
Topic 4
Efficiency in Perfectly
Competitive Markets
GADE, GDADE, GFICO, GDFICO

Academic Year 2017-2018.
Outline
4.1. Consumer surplus and the demand curve.

4.2. Producer surplus and the supply curve.
4.3. The efficiency of competitive markets.
4.4. Consumer and producer surplus and the
deadweight loss.
4.5. Externalities and public goods.
 References: Krugman and Wells (various chapters)

Pindyck and Rubinfeld (various chapters)
GADE, GDADE, GFICO, GDFICO, academic year 2017-2018. 2
Consumer Surplus and the Demand Curve
 A consumer’s willingness to pay for a good is the maximum
price at which he or she would buy that good.
 Individual consumer surplus is the net gain to an individual
buyer from the purchase of a good.
 Consumer Surplus can also be stated as:
Buyer’s Willingness to Pay – Price Paid
or
Area below demand curve but above price
Willingness to Pay and Consumer Surplus
 Total consumer surplus is the sum of the individual

consumer surpluses of all the buyers of a good.
 The term consumer surplus is often used to refer to

both individual and total consumer surplus.
Consumer Surplus in the Used Textbook
Market
Consumer Surplus in the Used Textbook

Market
Price of
book Aleisha’s consumer surplus:
$59-$30=$29
$59 Aleisha
Brad’s consumer surplus:
$45-$30=$15 The total consumer
surplus is given by
45 Brad the entire shaded
Claudia’s consumer
surplus: $35-$30=$5 area - the sum of the
35 Claudia individual consumer
30 Price = $30 surpluses of Aleisha,
25 Darren Brad, and Claudia
(i.e. it is equal to $29
+ $15 + $5 = $49).
10 Edwina
D
0 1 2 3 4 5 Quantity of books
Consumer Surplus
The total
Price of consumer surplus
computers generated by
purchases of a
good at a given
price is equal to
the area below the
Consumer demand curve but
surplus above that price.
$1,500 Price = $1,500
0 1 million
Quantity of computers
How Changing Prices Affect Consumer

Surplus
A fall in the price of a good increases consumer surplus

through two channels:
1. A gain to consumers who would have bought at the

original price and
2. A gain to consumers who are persuaded to buy by the

lower price.
How Changing Prices Affect Consumer
Surplus
Ex.: A Fall in the Market Price Increases Consumer Surplus
A decrease in
the price for
computers leads
to an increase in
counsumer
surplus
Outline
deadweight loss.
4.5. Externalities and public Goods.

Producer Surplus and the Supply Curve
 A potential seller’s cost is the lowest price at which he or

she is willing to sell a good.
 Individual producer surplus is the net gain to a seller
from selling a good.
 Producer surplus can also be stated as:
Price Received – Seller’s Cost
or
Area above the supply curve but below price
 Total producer surplus in a market is the sum of the
individual producer surpluses of all the sellers of a good.
Producer Surplus in the Used Textbook

Market
The total producer
S
surplus is given by
Price of book the entire shaded
$45
Engelbert area - the sum of the
individual producer
35 Donna surpluses of Andrew,
30 Price = $30 Betty and Carlos (i.e.
25 Carlos’s it is equal to $25 +
Carlos producer
surplus $15 + $5 = $45).
15 Betty Betty’s
producer
surplus
Andrew’s
5 Andrew producer
surplus
0 1 2 3 4 5
Quantity of books
Producer Surplus
Price of wheat
S The total producer
(per bushel)
surplus from sales of a
good at a given price is
the area above the
supply curve but below
$5 Price = $5 that price.
Producer
surplus
0 1 million
Quantity of wheat (bushels)
Changes in Producer Surplus

An increase in the price of a good increases
producer surplus through two channels:
 The gains of those who would have supplied the good

even at the original, lower price and
 The gains of those who are induced to supply the

good by the higher price.
Changes in Producer Surplus
Area A:
Producer surplus
Price of Increase in (170-150) *
gained by
wheat producer surplus 1 millon =
new sellers
(€/tonne) to original sellers (B) 20 millons €
(A)
Area B:
170
((170-150) *
0,5 millon)/2 =
5 millon €
150
1 millon 1,5 millon

Quantity of wheat (tonnes)
Outline
deadweight loss.
4.5. Externalities and public Goods.

Putting It Together: Total Surplus
 The total surplus generated in a market is:

the total net gain to consumers and producers from
trading in the market,
i.e. it is
the sum of the producer and the consumer surplus.
 The concepts of consumer surplus and producer surplus

can help us understand why markets are an effective way to
organize economic activity.
Total Surplus
S
Price of book
Consumer
surplus E
Equilibrium $30
price
Producer
surplus
0 1,000 Quantity of books
Equilibrium quantity
18
GADE, GDADE, GFICO, GDFICO, academic year 2017-2018.
Consumer Surplus, Producer Surplus, and
the Gains from Trade
 The previous graph shows that both consumers and
producers are better off because there is a market in
this good, i.e. there are gains from trade.
 These gains from trade are the reason everyone is
better off participating in a market economy than they
would be if each individual tried to be self-sufficient.
 But are we as well off as we could be? This brings us
to the question of the efficiency of markets.
19
The Efficiency of Markets: A Preliminary View

 Claim: The maximum possible total surplus is
achieved at market equilibrium.
 The market equilibrium allocates the consumption of
the good among potential consumers and sales of the
good among potential sellers in a way that achieves
the highest possible gain to society.
 By comparing the total surplus generated by the
consumption and production choices in the market
equilibrium, to the surplus generated by a different set
of production and consumption choices, we can show
that any change from the market equilibrium reduces
total surplus. => This will be shown in the next slides.
20
The Efficiency of Markets
Price of book
Consumer that buy
(€/book)
have a willingness to pay
of 30 € or more
All producers not selling

30 have costs higher
than 30 €
All producers selling

All consumers that do not buy
have costs of 30 €
have a willingness to pay
or less
lower than 30 €
Quantity of books
The market equilibrium maximizes total surplus

because the market performs four important functions:
1. It allocates consumption of the good to the potential buyers who
value it the most (those having the highest willingness to pay).
2. It allocates sales to the potential sellers who most value the
right to sell the good (those having the lowest cost).
3. It ensures that every consumer who makes a purchase values
the good more than every seller who makes a sale, so that all
transactions are mutually beneficial.
4. It ensures that every potential buyer who doesn’t make a
purchase values the good less than every potential seller who
doesn’t make a sale, so that no mutually beneficial transactions
are missed.
22
A caveat:
 It’s important to realize that although the market
equilibrium maximizes the total surplus, this does not
mean that it is the best outcome for every individual
consumer and producer.
 For example, a price floor that keeps the price up would
benefit some sellers.
 But: in the market equilibrium there is no way to make
some people better off without making others worse off -
and that’s the definition of efficiency.
23
Also keep in mind:

 There are situations where the market system may
generate the ‘wrong’ outcome  market failure.
 In the presence of market failure, the market is unable to
allocate resources efficiently (i.e. the market outcome is
inefficient).
 Consequently, in the presence of market failure the
market is not able to maximize total surplus.
24
Outline
deadweight loss.

Consumer and producer surplus and the

deadweight loss:
 Deadweight loss =
the loss in total surplus that occurs whenever an action
or a policy reduces the quantity transacted below the
efficient market equilibrium quantity.
 Triangle shaped area.
= Overall loss to society.
 We can apply the concepts of consumer and producer
surplus to pin down precisely the deadweight loss that for
example a governmental policy imposes.
 The following figure shows the effects of an excise tax on consumer and
producer surplus.
26
Applying Consumer and Producer Surplus:
The Efficiency Costs of a Tax
Price Fall in consumer
Fall in consumer surplus surplus:
due to tax A+B
Fall in producer
surplus:
C+F
Excise tax = T Tax revenue:

A+C
Deadweight loss:
B+F
Fall in producer surplus
due to tax
QT QE Quantity

 A tax causes a deadweight loss to society, because less

of the good is produced and consumed than in the
absence of the tax.
 Some mutually beneficial trades between producers
and consumers do not take place.
Price
Deadweight loss
Excise tax = T
Quantity
Deadweight Loss and Elasticities

 The general rule for economic policy is that other things
equal, you want to choose the policy that produces the
smallest deadweight loss.
 How can we predict the size of the deadweight loss
associated with a given policy?
 When demand or supply (or both) is inelastic a policy will
cause a relatively small decrease in quantity transacted and
a small deadweight loss.
 In contrast, when demand or supply (or both) is elastic a
policy will cause a relatively big decrease in quantity
transacted and a big deadweight loss.
 If the goal is to minimize deadweight loss of taxation,
then taxes should be imposed on goods and services
where either demand or supply (or both) is relatively
inelastic.
 Using a tax to purposely decrease the amount of a
harmful activity, such as underage drinking, will have the
most impact when that activity is elastically demanded or
supplied.
Outline
deadweight loss.

Externalities
 Externality
= activity of one entity that affects the welfare of another
and is not reflected in market prices.
 Positive or negative external effects.
 External cost
= an uncompensated cost that an individual or firm
imposes on others. => Negative externality.
 External benefit
= a benefit that an individual or firm confers on others
without receiving compensation. => Positive externality.
Example negative externality:
Pollution is delivered as a
public ‘bad‘ to the laundry
The pollution is a negative external

effect to the laundry. It is raising the
laundry‘s production costs
The cost for the brickworks The laundry is an unwilling

of making bricks is less than free rider: It can not charge
the real cost, which includes a price for the pollution it
the cost of pollution receives
Externalities
Example negative externality: production of bricks
 Costs =
Direct costs of the production of bricks +
External costs generated by brick production (i.e. the cost of
environmental pollution)
 Without government intervention: the brick factories have

no incentive to consider the external costs.
 To find the efficient level of activity, we need to know the
social cost (SC).
 SC =
private costs (PC) + external costs
(represents the damage done by the externality)
Externalities
 SC: Social Cost
Negative Externality
= private cost + external cost
Price, and
marginal  QOPT: Socially optimal quantity
External SC of
social cost bricks of brick production (i.e. including
of brick cost
production cost of pollution)
 QMKT: Quantity produced in a

P
SC S (Supply, market without government
O considering only
P private cost)
OPT action
PMKT E
MKT
 Without government
intervention, the free market
D
will not lead to an efficient
solution, as prices will reflect
private costs, but not the
Q Q Quantity of
OPT MKT bricks additional external costs.
Public Goods
Characteristics of Goods:
 Goods can be classified according to two attributes:
 whether they are excludable
 whether they are rival in consumption
 A good is excludable if the supplier of that good can

prevent people who do not pay from consuming it.
 A good is rival in consumption if the same unit of the good
cannot be consumed by more than one person at the same
time.
Public Goods
Characteristics of Goods (continued):
 A private good is excludable and rival in consumption.

 Private goods can be efficiently produced and consumed
in a competitive market.
 A public good is nonexcludable and nonrival in

consumption.
Public Goods
Thus, public goods have two key features:
 non-rivalry: The same unit of a public good can be
consumed by many individuals: one person enjoying the
good does not keep others from enjoying it.
 non-excludability: Once a good is provided to some
individuals it is not possible (or at least very costly) to
exclude others from benefiting from it.
 Leads to free-rider problem
Examples: street lightning, lighthouses, national defence.
Four Types of Goods
 Private goods: excludable and rival in consumption, like

wheat
 Public goods: nonexcludable and nonrival in
consumption, like national defense
 Common resources: nonexcludable but rival in
consumption, like clean water in a river
 Artificially scarce goods: excludable but nonrival in
consumption, like pay-per-view movies on cable TV
Characteristics of Goods
Rival in consumption Nonrival in consumption
Private goods Artificially scarce goods
Excludable • Wheat • Pay-per-view movies
• Chocolate bar • Computer software
Common resources Public goods

Non-
excludable • Clean water • Public TV
• Biodiversity • National defense
Why Markets Can Supply Only Private

Goods Efficiently
 Goods that are nonexcludable suffer from the free-rider
problem: individuals have no incentive to pay for their own
consumption and instead will take a “free ride” on anyone
who does pay.
 When goods are nonrival in consumption, the efficient
price for consumption is zero (i.e. they should be free) and
any positive price leads to inefficiently low consumption.
Providing Public Goods
 Most forms of public good provision by the private sector
have serious defects.
 Consequently, most public goods must be provided by the
government and paid for with taxes.
 The marginal social benefit of an additional unit of a public
good is equal to the sum of each consumer’s individual
marginal benefit from that unit.
 At the efficient quantity, the marginal social benefit equals
the marginal cost.
A Public Good
Marginal 25
$25 (a) Ted’s Individual Marginal Benefit Curve
benefit
18
18
12
12
7
7 MBT
3
3 1
1
0 1 2 3 4 5 6
Quantity of street cleansings (per month)
Marginal
benefit
21
$21
17 (b) Alice’s Individual Marginal Benefit Curve
17
13
13
9
9
5 MBA
5
1
1
0 1 2 3 4 5 6
Quantity of street cleansings (per month)
A Public Good
46
$46 (c) The Marginal Social Benefit Curve
Marginal The marginal social benefit curve of

benefit, a public good equals the vertical
35 sum of individual marginal benefit
marginal cost 35 21 curves
17 25
25
13 16
16 MSB
25
18 9 8
8 12 MC=$6
6 5
7 2 1
2 3 1
0 1 2 3 4 5 6
Quantity of street cleansings
Efficient quantity of the (per month)
public good
Providing Public Goods
 No individual has an incentive to pay for providing the

efficient quantity of a public good because each
individual’s marginal benefit is less than the marginal
social benefit.
Topic 4
Efficiency in Perfectly
Competitive Markets
GADE, GDADE, GFICO, GDFICO
Academic Year 2017-2018.

Introduction To Economics: Topic 4

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Introduction to Economics

GADE, GDADE, GFICO, GDFICO

4.1. Consumer surplus and the demand curve.

 References: Krugman and Wells (various chapters)

Willingness to Pay and Consumer Surplus

 Total consumer surplus is the sum of the individual

 The term consumer surplus is often used to refer to

Consumer Surplus in the Used Textbook

$1,500 Price = $1,500

How Changing Prices Affect Consumer

A fall in the price of a good increases consumer surplus

1. A gain to consumers who would have bought at the

2. A gain to consumers who are persuaded to buy by the

 References: Krugman and Wells (various chapters)

 A potential seller’s cost is the lowest price at which he or

Producer Surplus in the Used Textbook

Changes in Producer Surplus

 The gains of those who would have supplied the good

 The gains of those who are induced to supply the

1 millon 1,5 millon

 References: Krugman and Wells (various chapters)

 The total surplus generated in a market is:

 The concepts of consumer surplus and producer surplus

0 1,000 Quantity of books

The Efficiency of Markets: A Preliminary View

All producers not selling

All producers selling

The market equilibrium maximizes total surplus

Also keep in mind:

 References: Krugman and Wells (various chapters)

Consumer and producer surplus and the

Excise tax = T Tax revenue:

Applying Consumer and Producer Surplus:

 A tax causes a deadweight loss to society, because less

Deadweight Loss and Elasticities

Deadweight Loss and Elasticities

 References: Krugman and Wells (various chapters)

Example negative externality:

The pollution is a negative external

The cost for the brickworks The laundry is an unwilling

 Without government intervention: the brick factories have

 QMKT: Quantity produced in a

 A good is excludable if the supplier of that good can

 A private good is excludable and rival in consumption.

 A public good is nonexcludable and nonrival in

Examples: street lightning, lighthouses, national defence.

Four Types of Goods

 Private goods: excludable and rival in consumption, like

Private goods Artificially scarce goods

Excludable • Wheat • Pay-per-view movies

• Chocolate bar • Computer software

Common resources Public goods

• Biodiversity • National defense

Why Markets Can Supply Only Private

Marginal The marginal social benefit curve of

Providing Public Goods

 No individual has an incentive to pay for providing the

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