Analysis of Competitive Markets

In this section, we examine the social welfare

implications of competitive markets.
The approach taken here (and not the only one
possible), is to use the devices of Producer and
Consumer Surplus.
The social welfare from the production and
consumption of a particular amount of a good is
assumed to be the sum of the producer and
consumer surplus.

Welfare economics slide 1

 Optimality of competitive
markets
The principal claim is that social welfare (the sum of
producer and consumer surplus) is maximized at
the competitive price and quantity for a good.

A series of examples are worked to show that a

variety of policies and regulations, such as price
fixing, taxes, and subsidies, will, in general,
reduce social welfare from its maximum.

Welfare economics slide 2

 Key terms
Willingness to pay: The maximum amount a buyer
will pay for an amount of a good.
Consumer surplus: A buyer's willingness to pay
minus the amount actually paid.

Cost: The value of everything a seller must give up

to produce an amount of a good.
Producer surplus: The amount the seller receives for
the good minus the cost.
Welfare economics slide 3
 Consumer surplus can be measured using
the demand curve for a product.
P

Demand for tacos

P*

Q* Q

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 When Q* is sold, willingness to pay is the
shaded area.
P
Demand for tacos

P*

Q* Q

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 When Q* is sold at a price P*, consumers pay P*
times Q*.
1) Click to see the
cost to consumers.
P 2) Click again to
Consumer surplus see the shaded
area that is
P* consumer surplus.

Demand for tacos

Cost to
consumers
D

Q* Q

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 Producer surplus can be measured using the
supply curve for a product.

P Supply of tacos S

P'

Q' Q

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 The shaded area is the cost of producing Q' of
tacos. If the firm can sell at P', the total
receipts are P' times Q'.

Supply of tacos 1) Click to see

P the total
revenue.
P'
2) Click again to
see the costs.
Total
revenue
Costs

Q' Q

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 So producer surplus is the shaded area.

P S

Supply of tacos

P'

Q' Q

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 When QE is sold at a price of PE,
consumer surplus is A, and producer
surplus is B.
P
S

A
PE
B
D

QE Q

Welfare economics slide 10

Notice on the previous slide that at the market
equilibrium the sum of producer and
consumer surplus (welfare) is maximized.

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 Suppose Q' is sold at a price P' .
What's the effect on welfare compared
to the market?
P
S
P"

P*

Q' Q* Q

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 Consumer surplus is A . Producer surplus is
B plus C. Compared to the market, there is a
loss of D plus E. (Note that producers gain
B, while consumers lose B.)
P
S
A
P'
B D
PE
E

C D

Q' QE Q

Welfare economics slide 13

The next (hidden) slide shows the effects on
welfare of producing less than the market
amount.

Click for hidden slide

 What if MORE than the market equilibrium
quantity is produced?

P
S

PE

P' D

QE Q' Q

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 What if MORE than the market equilibrium
quantity is produced?

P
S

A F
E
P' B D
C

Q' Q

Welfare economics slide 17

When Q' is sold at P':

CS is A + E
PS is (B + C) - (C + E + F) = B - E - F

Therefore:
CS +PS is A + B - F

This is less than CS + PS in the market (= A + B).

Welfare economics slide 18

 Conclusion
If the demand curve (willingness to pay) is a good
measure of the value of a good, and
if the supply curve (the firm's cost) is a good
measure of the cost to society to produce a good,
then the best amount of the good to produce is where
supply and demand are equal.

Welfare economics slide 20