7_Consumers Producers and the Efficency of the Market

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A. RAMESHDEPARTMENT OF MANAGEMENT STUDIES

INDIAN INSTITUTE OF TECHNOLOGY ROORKEEROORKEE, UTTARAKHAND

INDIA - 247667

BM-505: Managerial Economics

Lecture 7: Consumers, Producers, and theEfficiency of Markets

7

Consumers, Producers, and theEfficiency of Markets

REVISITING THE MARKETEQUILIBRIUM

• Do the equilibrium price and quantitymaximize the total welfare of buyers andsellers?

• Market equilibrium reflects the way marketsallocate scarce resources.

• Whether the market allocation is desirable canbe addressed by welfare economics.

Welfare Economics

• Welfare economics is the study of how theallocation of resources affects economic well-being.

• Buyers and sellers receive benefits from takingpart in the market.

• The equilibrium in a market maximizes thetotal welfare of buyers and sellers.

Welfare Economics

• Equilibrium in the market results in maximumbenefits, and therefore maximum total welfarefor both the consumers and the producers ofthe product.

Welfare Economics

• Consumer surplus measures economic welfarefrom the buyer’s side.

• Producer surplus measures economic welfarefrom the seller’s side.



CONSUMER SURPLUS

• Willingness to pay is the maximum amount

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

good or service.

CONSUMER SURPLUS

• Consumer surplus is the buyer’s willingness to

pay for a good minus the amount the buyeractually pays for it.

Table 1 Four Possible Buyers’ Willingness to Pay

Copyright©2004 South-Western

CONSUMER SURPLUS

• The market demand curve depicts the variousquantities that buyers would be willing andable to purchase at different prices.

The Demand Schedule and the DemandCurve

The Demand Schedule and the Demand Curve

Price ofAlbum

0 Quantity ofAlbums

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



Measuring Consumer Surplus with the Demand Curve

Copyright©2003 Southwestern/ ThomsonLea rning

(a) Price = $80

Price ofAlbum

50

70

80

0

$100

Demand

1 2 3 4 Quantity ofAlbums

John’s consumer surplus ($20)

Measuring Consumer Surplus with the Demand Curve

Copyright©200 3 Southwestern/ ThomsonLea rning

(b) Price = $70Price of

Album

50

70

80

0

$100

Demand

1 2 3 4

Totalconsumersurplus ($40)

Quantity ofAlbums

John’s consumer surplus ($30)

Paul’s consumersurplus ($10)

Using the Demand Curve to MeasureConsumer Surplus

• The area below the demand curve and abovethe price measures the consumer surplus in themarket.

How the Price Affects Consumer Surplus


Consumersurplus

Quantity

(a) Consumer Surplus at Price P

Price

0

Demand

P 1

Q 1

B

A

C

How the Price Affects Consumer Surplus


Initialconsumer

surplus

Quantity

(b) Consumer Surplus at Price P

Price

0

Demand

A

BC

D EF

P 1

Q 1

P 2

Q 2

Consumer surplusto new consumers

Additional consumersurplus to initialconsumers

What Does Consumer Surplus Measure?

• Consumer surplus , the amount that buyers arewilling to pay for a good minus the amountthey actually pay for it, measures the benefitthat buyers receive from a good as the buyersthemselves perceive it .



PRODUCER SURPLUS

• Producer surplus is the amount a seller is paid

for a good minus the seller’s cost .• It measures the benefit to sellers participating

in a market.

The Costs of Four Possible Sellers

Copyright©2004 South-Western

Using the Supply Curve to Measure ProducerSurplus

• Just as consumer surplus is related to thedemand curve, producer surplus is closelyrelated to the supply curve.

The Supply Schedule and the Supply Curve

The Supply Schedule and the Supply CurveUsing the Supply Curve to Measure ProducerSurplus

• The area below the price and above the supplycurve measures the producer surplus in amarket.



Measuring Producer Surplus with the Supply Curve


Quantity ofHouses Painted

Price ofHouse

Painting

500

800

$900

0

600

1 2 3 4

(a) Price = $600

Supply

Grandma’s producersurplus ($100)

Measuring Producer Surplus with the Supply Curve


Quantity ofHouses Painted

Price ofHouse

Painting

500

800

$900

0

600

1 2 3 4

(b) Price = $800

Georgia’s producersurplus ($200)

Totalproducersurplus ($500)

Grandma’s producersurplus ($300)

Supply

How the P rice Affects Producer Surplus


Producersurplus

Quantity

(a) Producer Surplus at Price P

Price

0

Supply

B

A

C

Q 1

P 1

How the Price Affects Producer Surplus

Quantity

(b) Producer Surplus at Price P

Price

0

P 1B

C

Supply

A

Initialproducersurplus

Q 1

P 2

Q 2

Producer surplusto new producers

Additional producersurplus to initialproducers

D EF

MARKET EFFICIENCY

• Consumer surplus and producer surplus maybe used to address the following question:

– Is the allocation of resources determined by freemarkets in any way desirable?

MARKET EFFICIENCY

Consumer Surplus

= Value to buyers – Amount paid by buyers

and

Producer Surplus= Amount received by sellers – Cost to sellers



MARKET EFFICIENCY

Total surplus

= Consumer surplus + Producer surplus

or

Total surplus= Value to buyers – Cost to sellers

MARKET EFFICIENCY

• Efficiency is the property of a resource

allocation of maximizing the total surplusreceived by all members of society.

MARKET EFFICIENCY

• In addition to market efficiency, a socialplanner might also care about equity – thefairness of the distribution of well-beingamong the various buyers and sellers.

Consumer and Producer Surplus in the Market Equilibrium


Producersurplus

Consumersurplus

Price

0 Quantity

Equilibriumprice

Equilibriumquantity

Supply

Demand

A

C

B

D

E

MARKET EFFICIENCY

• Three Insights Concerning Market Outcomes – Free markets allocate the supply of goods to the

buyers who value them most highly, as measuredby their willingness to pay.

– Free markets allocate the demand for goods to thesellers who can produce them at least cost.

– Free markets produce the quantity of goods thatmaximizes the sum of consumer and producersurplus.

The Efficiency of the Equilibrium Quantity

Quantity

Price

0

Supply

Demand

Costto

sellers

Costto

sellers

Valueto

buyers

Valueto

buyers

Value to buyers is greaterthan cost to sellers.

Value to buyers is lessthan cost to sellers.

Equilibriumquantity



Evaluating the Market Equilibrium

• Because the equilibrium outcome is an

efficient allocation of resources, the socialplanner can leave the market outcome ashe/she finds it.

• This policy of leaving well enough alone goesby the French expression laissez faire.


• Market Power

– If a market system is not perfectly competitive,market power may result.

• Market power is the ability to influence prices.• Market power can cause markets to be inefficient

because it keeps price and quantity from the equilibriumof supply and demand.


• Externalities – created when a market outcome affects individuals

other than buyers and sellers in that market. – cause welfare in a market to depend on more than

just the value to the buyers and cost to the sellers.

• When buyers and sellers do not takeexternalities into account when deciding howmuch to consume and produce, the equilibrium

in the market can be inefficient.

Summary

• Consumer surplus equals buyers’ willingnessto pay for a good minus the amount theyactually pay for it.

• Consumer surplus measures the benefit buyersget from participating in a market.

• Consumer surplus can be computed by findingthe area below the demand curve and abovethe price.

Summary

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

• Producer surplus measures the benefit sellersget from participating in a market.

• Producer surplus can be computed by findingthe area below the price and above the supplycurve.

Summary

• An allocation of resources that maximizes thesum of consumer and producer surplus is saidto be efficient.

• Policymakers are often concerned with theefficiency, as well as the equity, of economicoutcomes.



Summary

• The equilibrium of demand and supply

maximizes the sum of consumer and producersurplus.

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

• Markets do not allocate resources efficiently inthe presence of market failures.

7_Consumers Producers and the Efficency of the Market

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