1

Quick Review! What is welfare economics?

• Measures how the allocation of resources affects economic well being

How do we measure this?

• Consumer & Producer Surplus

How can we find the best situation for both consumers and producers?

• By maximizing total surplus

• This happens at the equilibrium

2

The economic goal of any society:

CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

Maximize total

surplus!

3CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

Your Turn!

How do we calculate consumer surplus?

• CS = WTP - Price

• CS = (value to buyers) – (amount paid by buyers)

What Does Consumer Surplus Measure?

• CS measures the benefit buyers receive from participating in the market.

.

4

Your Turn!

How do we calculate producer surplus?

• PS = Price – cost of production

• PS = (amount received by sellers) – (cost to sellers)

What does producer surplus measure?

• PS measures the benefit sellers receive from participating in the market

CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

5

How do you measure the economic well-being of a

society?Total surplus = CS + PS

TS measures the total gains from trade in a market.

CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

6CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

Measuring Society’s Well-Being

Total surplus

= CS + PS

= (value to buyers) – (amount paid by buyers)

+ (amount received by sellers) – (cost to sellers)

= (value to buyers) – (cost to sellers)

7

Your turn!

What is total surplus?

• TS = value to buyers – cost to sellers

• TS = WTP - Cost

What does total surplus measure?

• A societies economic well being

What is the economic goal of any society?

• To Maximize total surplus!

CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

8CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

Efficiency

An allocation of resources is efficient if it maximizes total surplus. Efficiency means:

• Raising or lowering the quantity of a good would not increase total surplus.

• The goods are being produced by the producers with lowest cost.

• The goods are being consumed by the buyers who value them most highly.

= (value to buyers) – (cost to sellers)Total

surplus

9

Your turn!

When is a market efficient?

• When it maximizes total surplus

In an efficient market, what would happen if the quantity of a good were changed?

• The total surplus would decrease

CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

10CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

Evaluating the Market Equilibrium

Market eq’m: P = $30 Q = 15,000

Total surplus = CS + PS

Is the market equilibrium efficient?

0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

S

D

CS

PS

11CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

Which Buyers Get to Consume the Good?

0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

S

D

Every buyer whose WTP is ≥ $30 will buy.

Every buyer whose WTP is < $30 will not.

So, the buyers who value the good most highly are the ones who consume it.

12

Your turn! What is the consumer surplus in this example?

• ½ x base x height

• ½ x 15 x 30

• = $225

Which buyers will consume (purchase) this good?

• All buyers whose willingness to pay is equal to or greater than $30

Which buyers will not consume this good?

• All buyers whose willingness to pay is less than $30

13CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

Which Sellers Produce the Good?

0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

S

D

Every seller whose cost is ≤ $30 will produce the good.

Every seller whose cost is > $30 will not.

Hence, the sellers with the lowest cost produce the good.

14

Your turn! What is the producer surplus in this example?

• ½ x base x height

• ½ x 15 x 15

• = $112.5

Which sellers produce the good?

• Sellers whose costs are $30 or less

Which sellers will not produce the good?

• Sellers whose costs are more than $30

15

Your Turn

At equilibrium (P=$30, Q=15) what is the total surplus?

• TS = CS + PS

• TS = $225 + $112.50

• TS = $337.50

CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

16CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

Does Increasing Equilibrium Q Maximize Total Surplus?

0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

S

D

At Q = 20, value to consumers at this quantity is $20

cost of producing the unit is $35

Hence, can increase total surplus by reducing Q.

This is true at any Q greater than 15.

17CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

Does reducing Equilibrium Q Maximize Total Surplus?

0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

S

D

At Q = 10, value to consumers at this quantity is $40

cost of producing the unit is $25

Hence, can increase total surplus by increasing Q.

This is true at any Q less than 15.

18CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

Evaluating the Market Equilibrium: Summary

The market equilibrium is efficient:

• The equilibrium Q maximizes total surplus.

• The goods are produced by the producers with lowest cost,

• and consumed by the buyers who value them most highly.

The govt cannot improve on the market outcome.

Laissez faire (French for “allow them to do”): the govt should not interfere with the market.

19

Your Turn!

Why wouldn’t it be efficient (or effective) for a government to determine quantity, rather than letting the market adjust naturally to equilibrium?

In other words, why shouldn’t the government interfere with the market?

CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

20CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

Why Non-Market Allocations Are Usually Bad

Suppose the allocation of resources were instead determined by a central planner (e.g., the Communist leaders of the former Soviet Union.)

To choose an efficient allocation, the planner would need to know every seller’s cost and every buyer’s WTP, for each of the thousands of goods produced in the economy.

This is practically impossible, so centrally planned economies are never very efficient.

21CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

Adam Smith and the Invisible Hand

“Every individual…neither intends to promote the public interest, nor knows how much he is promoting it….

Adam Smith, 1723-1790

Passages from The Wealth of Nations, 1776

He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”

an invisible hand

22

Your turn!

What is the invisible hand, and how does this shape market behavior?

What does the “invisible hand” suggest that governments should do?

CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

23CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

CONCLUSION This chapter used welfare economics to

demonstrate one of the Ten Principles:Markets are usually a good way to organize economic activity.

But we assumed markets are perfectly competitive.

In the real world, sometimes there are market failures, when unregulated markets fail to allocate resources efficiently. Causes:• market power – a single buyer or seller can

influence the market price, e.g. monopoly

• externalities – side effects of transactions, e.g. pollution

24CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

CONCLUSION

When markets fail, public policy may remedy the problem and increase efficiency.

Welfare economics sheds light on market failures and govt policies.

Despite the possibility of market failure, the assumptions in this chapter work well in many markets, and the invisible hand remains extremely important.