07 Consumers Producers

8/3/2019 07 Consumers Producers

http://slidepdf.com/reader/full/07-consumers-producers 1/67

3

SUPPLY AND DEMAND II: MARKETS AND WELFARE



7

Consumers, Producers, and the

Efficiency of Markets



CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 3

Revisiting The Market Equilibrium

• The theory of supply and demand shows howmarkets allocate scarce resources amongcompeting needs.

• But are the equilibrium price and quantity theright price and the right quantity from society’spoint of view?

• Do they maximize the total welfare of buyers and

sellers?• Whether the market allocation is desirable or not

is the topic of welfare economics.




Welfare Economics

• Welfare economics is the study of how theallocation of resources affects economicwell-being

• It shows that: – Both buyers and sellers receive benefits from

taking part in the market

– The equilibrium outcome—that we saw inChapter 4—maximizes the total welfare ofbuyers and sellers




Welfare Economics: two mainconcepts

• Consumer surplus measures economicwelfare of the buyer.

• Producer surplus measures economicwelfare of the seller.




Willingness to pay

• To define consumer surplus we first needto define ―willingness to pay.‖

• Willingness to pay is the maximum amount

that a buyer will pay for a good.• It measures how much the buyer values the

good.



Willingness to pay

• Assume there is a commodity such that everyadditional unit of it increases a consumer’shappiness by the same amount

– In other words, the consumption of additionalunits of this commodity induces neither boredomnor addiction

– Possible examples: potato chips? candy?

• Then the consumer’s willingness to pay for aproduct is an accurate measure of thehappiness that he or she gets from it




Willingness to pay

• continuation from previous slide

• If a bag of potato chips provides an unchangingamount of happiness, and

• if your willingness to pay is

– 4 bags of potato chips for a shirt and – 2 bags for a cup of coffee, then – one can safely say that the shirt makes you twice as happy

as the cup of coffee – In other words, your willingness to pay for a commodity is

an accurate measure of how much you like that thing• For a given dollar price of a bag of potato chips, your

willingness to pay can also be expressed in dollars




Willingness to pay

• continuation from previous slide • For example,

– if you are willing to pay $15 for a particular shirt, and – if a bag of potato chips always gives you 3 ―haps‖ of

happiness, and sells at the price of $0.50 each, then – the shirt gives you 90 ―haps‖ of happiness.

• In other words, your willingness to pay for the shirtis

– a monetary measure of the happiness you get fromthe shirt, which is – proportional to the happiness you get from the shirt,

as measured in ―haps‖




Table 1 Four Possible Buyers’ Willingness to Pay

For a mint-conditionrecording of ElvisPresley’s first album



11

Consumer Surplus

• Consumer surplus is the buyer’s willingness topay for a good minus the amount the buyeractually pays for it.

– Example: If the Elvis album’s price is $75…

Buyer Willingnessto Pay

ConsumerSurplus

Buy?

John 100 25 YesPaul 80 5 Yes

George 70 -5 No

Ringo 50 -25 No




Market Demand

• The market demand schedule/curve showsthe various quantities that buyers would bewilling and able to purchase at different prices.

– Chapter 4• We can use the willingness-to-pay numbers to

calculate the quantities demanded at everyprice

– That is, we can calculate the market demandschedule/curve from the willingness-to-paynumbers



13

The Demand Schedule Buyer Willingness

to Pay

John 100

Paul 80

George 70

Ringo 50



Figure 1 The Demand Curve

Copyright©2003 Southwestern/Thomson Learning

Price of Album

0 Quantity of Albums

Demand

1 2 3 4

$100 John ’ s willingness to pay 80 Paul ’ s willingness to pay 70 George

’ s willingness to pay

50 Ringo ’ s willingness to pay

Buyer Willingness to Pay

John 100

Paul 80

George 70

Ringo 50

The height of thedemand curve at any

quantity shows thewillingness to pay ofwhoever bought thelast unit.




Area of a Rectangle

Height

Width

Area = Width × Height



Figure 2 Measuring Consumer Surplus with theDemand Curve

(a) Price = $80.01 Price of

Album

50 70 80

0

$100

Demand

1 2 3 4 Quantity of Albums

John’s willingness to pay ($100)


ConsumerSurplus

Buy?

John 100 20 Yes

Paul 80 0 No

George 70 -10 No

Ringo 50 -30 No

1. The area under the demand

curve measures the totalwillingness to pay for thequantity demanded.

2. It is also the maximumwillingness to pay that couldbe generated from thatquantity.




The market and the planner

• Suppose the government has one copy of the Elvis album. Thegovernment’s goal is to give it toone of the four guys so as togenerate the maximum happiness.

• Who will get the government’scopy?

• Obviously, John.• Lesson: The market does thebest that the government couldhave done

Price = $80


John 100

Paul 80

George 70

Ringo 50



Figure 2 Measuring Consumer Surplus with theDemand Curve

(b) Price = $70.01 Price of

Album

50

70 80

0

$100

Demand 1 2 3 4 Quantity of

Albums


ConsumerSurplus

Buy?

John 100 30 Yes

Paul 80 10 Yes

George 70 0 No

Ringo 50 -20 No

John’s willingness to pay Paul’s willingness to pay

1. The area under the demand

curve measures the totalwillingness to pay for thequantity demanded.

2. It is also the maximumwillingness to pay that could

be generated from thatquantity.



Interpersonal comparability

• We just saw – that the total area under the demand curve is $180, and – that is also the total willingness to pay of John and Paul

• But can we say it is the total happiness of John and Paul?• Yes ,

– if there is a commodity—say, a bag of potato chips—thatprovides an unchanging amount of happiness to the consumer,and

– if John’s happiness and Paul’s happiness are comparable, and – if both John and Paul get the same happiness from a bag of

potato chips

• That’s a lot of if’s!• But we will make these simplifying assumption anyway

– Not just for John and Paul, but for everybody




Utilitarianism

• The idea that – the happiness of an individual can be measured

numerically, – the happiness of a group of people can be measured

numerically, – the happiness of a group of people is simply the sumof the numbers representing the happiness of theindividual members of the group, and that

– social policy should seek to maximize the total

happiness of society, – is called utilitarianism

• The welfare analysis in this chapter takesutilitarianism as its guiding philosophy





The market and the planner

• Suppose the government has two copies of the Elvis album. Thegovernment’s goal is to give them

to two of the four guys so as togenerate the maximum happiness.

• Who will get the government’scopies?

• Obviously, John and Paul.

• The market does the best thatthe government could have done

Price = $70


John 100

Paul 80

George 70

Ringo 50



Willingness to Pay from the Demand Curve

Quantity

(a) Willingness to Pay at Price P Price

0

Demand

P 1

Q 1

B

A

C

The area under the demandcurve also measures themaximum willingness to pay

that could be obtained fromQ 1 units




Using the demand curve to measurewillingness to pay

• In general, the area under the demandcurve up to the quantity demanded is agraphical measure of the total willingness

to pay of the buyers.

• It is also the maximum willingness to paythat can be obtained from that quantity

– That is, the government could not give awaythat quantity in a way that generates higherwillingness to pay.



Figure 3 How the Price Affects ConsumerSurplus

Consumer surplus

Quantity

(a) Consumer Surplus at Price P Price

0

Demand

P 1

Q 1

B

A

C

TotalPayment

Consumer Surplus (ABC) +Total Payment (OBCQ1) =Willingness to Pay (OACQ1)




Using the Demand Curve to MeasureConsumer Surplus

• In general, the area below the demand curve and above the price measures theconsumer surplus.



Figure 3 How the Price Affects ConsumerSurplus

Initial consumer

surplus

Quantity

(b) Consumer Surplus at Price P Price

0

Demand

A

B C

D E F

P 1

Q 1

P 2

Q 2

Consumer surplus to new consumers

Additional consumer surplus to initial

consumers



Shifts in Demand

• We have seen that the demand curve canshift, for reasons such as – a change in tastes, and – a change in the prices of related goods

• See chapter 4

• Given that the demand for a product can shiftas a result of a change in the price of arelated good, does it make sense to say that

the area under the demand curve measuresthe happiness consumers get from theproduct?




Shifts in Demand

• Continued from the previous slide • Yes!

– Keep in mind that the area under the demand curve is a monetary measure of the happiness obtained by buyers

– The objective or psychological happiness obtained from a shirt may beunchanged even if the monetary willingness to pay for the shirt

changes, perhaps because of a change in the price of a related good• In an earlier slide, a bag of potato chips was assumed to always

provide 3 ―haps‖ of happiness, and sold at a price of $0.50.Consequently, consumers were wiling to pay $15 for a shirt thatprovided 90 ―haps‖ of happiness.

• It follows that if the price of a bag of potato chips rises to $1,

consumers would then be willing to pay $30 for the same shirt,leading to an upward shift in the demand curve for shirts.





Producer Surplus

• Producer surplus is the amount a seller ispaid for a good minus the seller’s cost .

• It measures the net benefit to sellers

• It is almost but not quite the same as profit. – We’ll discuss this later




Cost of production

• The cost of production is the market valueof all resources used in production

– By all , I do mean all . Even if some resources

used in production were obtained for free,their market value must be included in cost .



Table 2 The Cost of Painting a House forFour Possible Sellers




The Supply Schedule and theSupply Curve

Seller Cost ($)

Mary 900

Frida 800

Georgia 600

Grandma 500



Figure 4 The Supply Schedule and the SupplyCurve

Seller Cost ($)

Mary 900

Frida 800

Georgia 600

Grandma 500

The height of the supply curveat any quantity shows theproduction cost to whoeverproduces the last unit.




Producer Surplus

• Producer surplus is the amount a seller is paidminus the seller’s cost

– Example: If the going price for getting a house paintedis $700 we get the following table.

Seller Cost ($) ProducerSurplus

Sell?

Mary 900 -200 No

Frida 800 -100 No

Georgia 600 100 Yes

Grandma 500 200 Yes




Using the Supply Curve to MeasureProducer Surplus

• The area below the price and above thesupply curve measures the producersurplus.



Figure 5 Measuring Producer Surplus with theSupply Curve

Quantity of Houses Painted

Price of House Painting

500

800

$900

0

600

1 2 3 4

(a) Price = $599.99

Supply

Grandma’s Cost($500)


Sell?

Mary 900 -300 No

Frida 800 -200 No

Georgia 600 0 No

Grandma 500 100 Yes

1. The area under

the supply curve isthe cost of thequantity supplied

2. It is also thelowest cost for thatquantity




Is there a better alternative to themarket system?

• If the government had to get one house painted, who would get the

job?

• Grandma, of course, if thegovernment had any sense.

• And that’s exactly what happensin the market outcome.

• The market achieves the bestthat the government could haveachieved

Seller Cost ($)

Mary 900

Frida 800

Georgia 600

Grandma 500



Figure 5 Measuring Producer Surplus with theSupply Curve

Quantity of Houses Painted

Price of House Painting

500

800 $900

0

600

1 2 3 4

(b) Price = $799.99

Supply


Sell?

Mary 900 -100 No

Frida 800 0 No

Georgia 600 200 Yes

Grandma 500 300 Yes

Grandma’s cost

Georgia’s cost

1. The area under

the supply curve isthe cost of thequantity supplied

2. It is also thelowest cost for thatquantity




Is there a better alternative to themarket system?

• If the government had to get two houses painted, who would getthe job?

• Grandma and Georgia, of course.• And that’s exactly what happens

in the market outcome.

• The market achieves the bestthat the government could haveachieved

Seller Cost ($)

Mary 900

Frida 800

Georgia 600

Grandma 500

Figure 6 How the Price Affects Producer



Figure 6 How the Price Affects ProducerSurplus

Producer surplus

Quantity

(a) Producer Surplus at Price P Price

0

Supply

B

A

C

Q 1

P 1

ProductionCost

Total Revenue (OBCQ1) =Production Cost (OACQ1) +Producer Surplus (ABC)

Figure 6 How the Price Affects Producer



Figure 6 How the Price Affects ProducerSurplus

Quantity

(b) Producer Surplus at Price P Price

0

P 1 B C

Supply

A

Initial producer surplus

Q 1

P 2

Q 2

Producer surplus to new producers

Additional producer surplus to initial producers

D

E

F




MARKET EFFICIENCY

• Consumer surplus and producer surplusmay be used to address the followingquestions:

– Is our free market system a good way ofrunning our economy?

– Could we design a better system?




MARKET EFFICIENCY

Consumer Surplus= Value to buyers – Amount paid by buyers

and

Producer Surplus= Amount received by sellers – Cost tosellers




MARKET EFFICIENCY

Total surplus= Consumer surplus + Producer surplus

= Value to buyers – Amount paid by buyers

+ Amount received by sellers – Cost tosellers

= Value to buyers – Cost to sellers



MARKET EFFICIENCY

• In fact, we can go further and say that

• Total Surplus = maximum willingness topay – minimum production cost





MARKET EFFICIENCY

• An economic outcome is efficient if there isno feasible way to make the total surplusany higher.

Figure 7 Consumer and Producer Surplus in



Figure 7 Consumer and Producer Surplus inthe Market Equilibrium

Producer surplus

Consumer surplus

Price

0 Quantity

Equilibrium price

Equilibrium quantity

Supply

Demand

A

C B

D

E

Figure 7 Consumer and Producer Surplus in



Cost

Consumer surplus

g pthe Market Equilibrium

Producer surplus

Price

0 Quantity

Equilibrium price


Supply

Demand

A

C B

D

E

Total Value (or,willingness to pay)

TotalSurplus

Th b f ibl



Cost (also,Minimum Cost)

Consumer surplus

The best feasible outcome

Producer surplus

Price

0 Quantity

Equilibrium price


Supply

Demand

A

C B

D

E

Total Value (also,Maximum Value)

Maximum TotalSurplus

As long as we producethe equilibrium quantity,

it would be impossibleto increase the TotalSurplus by reallocatingproduction andconsumption.

But is the

equilibriumoutput the rightoutput toproduce?




Maximum Cost saved


Price

0 Quantity

Equilibrium price


Supply

Demand

A

C B

D

E

Minimum WTP lost

Alternative

Society would beworse off if it produces

less than theequilibrium quantity




Minimum Cost


Price

0 Quantity

Equilibrium price


Supply

Demand

A

C B

D

E

Society would beworse off if it produces

more than theequilibrium quantity

Maximum Value ofextraoutput

Alternative




MARKET EFFICIENCY

• Three Insights Concerning MarketOutcomes

– Free markets allocate the goods produced to

the buyers who value them most highly, asmeasured by their willingness to pay.

– Free markets allocate production of goods tothose who can produce them at least cost.

– Free markets produce the quantity of goodsthat maximizes the sum of consumer andproducer surplus.

Figure 8 The Efficiency of the Equilibrium



Figure 8 The Efficiency of the EquilibriumQuantity

Quantity

Price

0

Supply

Demand

Cost to

sellers

Cost to

sellers

Value to

buyers

Value to

buyers

Value to buyers is greater than cost to sellers. Value to buyers is less

than cost to sellers.





The Invisible Hand

• We pursue our self-interest, not the socialinterest

• It is, therefore, natural to think that the free

market would lead to chaos• And yet, as we just saw, the free market

outcome is unimprovable

• This idea was most famously proposed byAdam Smith (1723 – 1790), the father ofmodern economics.




The Invisible Hand

• ...[E]very individual … neither intends to promote thepublic interest, nor knows how much he is promoting it.… [H]e intends only his own security; and by directingthat industry in such a manner as its produce may be ofthe greatest value, he intends only his own gain, and he

is in this, as in many other cases, led by an invisiblehand to promote an end which was no part of hisintention. Nor is it always the worse for the society that itwas no part of it. By pursuing his own interest hefrequently promotes that of the society more effectuallythan when he really intends to promote it. I have neverknown much good done by those who affected to tradefor the public good.

• The Wealth of Nations , Adam Smith, 1776




Ticket Scalping

• Ticket scalping is often frowned upon andsometimes considered illegal – See http://en.wikipedia.org/wiki/Ticket_resale

• But a typical view among economists isthat ―consenting adults should be able tomake economic trades when they think itis to their mutual advantage‖

• Scalping increases the economy’sefficiency

http://en.wikipedia.org/wiki/Ticket_resale

http://en.wikipedia.org/wiki/Ticket_resale




Market for organs

• Should people be allowed to sell, say, theirkidneys?

• The efficiency of the economy will increase.• What about fairness?

– Rich will buy the kidneys; the poor will not. But – Right now healthy people have extra kidneys

while the sick have none. – The sale of organs may be more acceptable if

organ purchases by the poor were paid for withtaxpayers’ money so that rich and poor had equalaccess



WHEN MARKETS FAIL





However, markets can go wrong

• Market Power

• Externalities

• Fairness




MONOPOLY

• If a market system is not perfectlycompetitive, firms may have market power .

– Market power is the ability to influence prices.

– Market power can cause markets to beinefficient because it keeps price and quantityfrom the equilibrium of supply and demand.




EXTERNALITIES

• Externalities – are created when a market outcome affects

individuals other than buyers and sellers in thatmarket.

– cause welfare in a market to depend on morethan just the value to the buyers and cost tothe sellers.

• When buyers and sellers do not take externalities

into account when deciding how much toconsume and produce, the equilibrium in themarket can be inefficient.




FAIRNESS

• In addition to market efficiency, a socialplanner might also care about equity – thefairness of the distribution of well-being

among the various buyers and sellers.• The free market economic system is

efficient but not necessarily fair



Health Care: a big exception

• In most advanced countries, government policiesregarding health care routinely disregard the idea thatfree markets are best

• In the United Kingdom, the government buildshospitals, hires doctors and nurses, buys

pharmaceutical drugs, and provides medical care to allresidents• Patients get no bills; tax revenues are used to pay all

costs• Fees of private doctors are paid by the government

• Performance indicators are high• Costs are low• There is virtually no clamor for privatization





Summary

• Consumer surplus equals buyers’willingness to pay for a good minus theamount they actually pay for it.

• Consumer surplus measures the benefitbuyers get from participating in a market.

• Consumer surplus can be computed by

finding the area below the demand curveand above the price.




Summary

• Producer surplus equals the amount sellersreceive for their goods minus their costs ofproduction.

• Producer surplus measures the benefitsellers get from participating in a market.

• Producer surplus can be computed by

finding the area below the price and abovethe supply curve.




Summary

• An allocation of resources that maximizesthe sum of consumer and producer surplusis said to be efficient.

• Policymakers are often concerned with theefficiency, as well as the equity, ofeconomic outcomes.



Summary

• The equilibrium of demand and supplymaximizes the sum of consumer andproducer surplus.

• This is as if the invisible hand of themarketplace leads buyers and sellers toallocate resources efficiently.

• Markets do not allocate resourcesefficiently in the presence of marketfailures.

07 Consumers Producers

Documents

Transcript of 07 Consumers Producers