Ch7 Handouts

8/14/2019 Ch7 Handouts

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ECO101 BY Bilgen Susanli

CH7: Consumers, Producers,

and the Efficiency of Markets

In this chapter,In this chapter,

look for the answers to these questions:look for the answers to these questions:

What is consumer surplus? How is it related to the demandcurve?

What is producer surplus? How is it related to the supply curve?

Do markets produce a desirable allocation of resources? Or couldthe market outcome be improved upon?

2 These slides are incomplete unless you at tend class

These slides are incomplete unless you attend class

Welfare Economics

Recall, the allocation of resources refers to:

how much of each good is produced

which producers produce it

which consumers consume it

Welfare economics studies how the allocation of resourcesaffects economic well-being.

First, we look at the well-being of consumers.

3


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Willingness to Pay (WTP)

A buyers willingness to pay for a good is the maximumamount the buyer will pay for that good.

WTP measures how much the buyer values the good.

name WT P

Ahmet $250

Ceren 175

Filiz 300

Can 125

Example:

4 buyers WTP

for an iPod


WTP and the Demand Curve

Q: If price of iPod is $200, who will buy an iPod, and what isquantity demanded?

A: Ahmet & Filiz will buy an iPod, Ceren

& Can will not.

Hence, Qd= 2

when P = $200.

name WT P

Ahmet $250

Ceren 175

Filiz 300

Can 125



Derive the

demand

schedule:

4Can, Ceren,

Ahmet, Filiz0 125

3Ceren, Ahmet,

Filiz126 175

2Ahmet, Filiz176 250

1Filiz251 300

0nobody$301 & up

Qdwho buysP (price

of iPod)


name WT P

Ahmet $250

Ceren 175

Filiz 300

Can 125


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$0

$50

$100

$150

$200

$250

$300

$350

0 1 2 3 4


P Qd

$301 & up 0

251 300 1

176 250 2

126 175 3

0 125 4

P

Q


$0

$50

$100

$150

$200

$250

$300

$350

0 1 2 3 4

About the Staircase Shape

This D curve looks like a staircasewith 4 steps one per buyer.

P

Q

If there were a huge # of buyers, as in acompetitive market,

there would be a huge #of very tiny steps,

and it would look morelike a smooth curve.


$0

$50

$100

$150$200

$250

$300

$350

0 1 2 3 4


At any Q,the height ofthe D curve is theWTP of themarginal buyer, the

buyer who wouldleave the market if P

were any higher.

P

Q

FilizsWTP

AhmetsWTP

CerensWTP

CansWTP



4/15

Consumer Surplus (CS)

Consumer surplus is the amount a buyer is willing to payminus the amount the buyer actually pays:

CS = WTP P

name WT P

Ahmet $250

Ceren 175

Filiz 300

Can 125

Suppose P = $260.

Filizs CS = $300 260 = $40.

The others get no CS because they do notbuy an iPod at this price.

Total CS = $40.


$0

$50

$100

$150

$200

$250

$300

$350

0 1 2 3 4

CS and the Demand Curve

P

Q

FilizsWTP P = $260

Filizs CS =$300 260 = $40

Total CS = $40


$0

$50

$100

$150

$200

$250

$300

$350

0 1 2 3 4


P

Q

FilizsWTP

AhmetsWTP

Instead, supposeP = $220

Filizs CS =$300 220 = $80

AhmetsCS =$250 220 = $30

Total CS = $110



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$0

$50

$100

$150

$200

$250

$300

$350

0 1 2 3 4


P

Q

The lesson:

Total CS equals the areaunder

the demand curve above

the price, from 0 to Q.


0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

$

CS with Lots of Buyers & a Smooth D Curve

The demand for shoes

D

1000s of pairs ofshoes

Priceper pair

At Q= 5(thousand), themarginal buyer is willingto pay $50 for pair ofshoes.

Suppose P = $30.

Then his consumersurplus = $20.


0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

CS with Lots of Buyers & a Smooth D Curve

The demand for shoes

D

CS is the area b/w Pand the D curve, from 0to Q.

Recall: area ofa triangle equals

x base x heightHeight =$60 30 = $30.

So,CS = x 15 x $30

= $225.

h

$



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0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

How a Higher Price Reduces CS

D

If P rises to $40,

CS = x 10 x $20= $100.

Two reasons for the fall inCS.

1. Fall in CSdue to buyers

leaving market

2. Fall in CS due toremaining buyerspaying higher P


0

5

10

15

20

25

30

35

40

45

50

0 5 10 15 20 25

P

Q

demand curve

A. Find marginalbuyers WTP atQ= 10.

B. Find CS forP = $30.

Suppose P falls to $20.How much will CS increasedue to

C. buyers enteringthe market

D. existing buyers payinglower price

$

A C T I V E L E A R N I N GA C T I V E L E A R N I N G 11

Consumer surpConsumer surpluslus

17


AnswersAnswers

0

5

10

15

20

2530

35

40

45

50

0 5 10 15 20 25

P

$

Q

demand curve

A. At Q= 10, marginalbuyers WTP is $30.

B. CS = x 10 x $10

= $50P falls to $20.

C. CS for theadditional buyers= x 10 x $10 = $50

D. Increase in CSon initial 10 units= 10 x $10 = $10018


7/15

Cost and the Supply Curve

name cost

Ali $10

Mustafa 20

Mehmet 35

A seller will produce and sell the

good/service only if the

price exceeds his or her cost.

Hence, cost is a measure of

willingness to sell.

Cost is the value of everything a seller must give up toproduce a good (i.e., opportunity cost).

Includes cost of all resources used to produce good, including

value of the sellers time.

Example: Costs of 3 sellers in the hair cut business.



335 & up

220 34

110 19

0$0 9

QsPDerive the supply schedule from

the cost data:

name cost

Ali $10

Mustafa 20

Mehmet 35



$0

$10

$20

$30

$40

0 1 2 3

P

Q

P Qs

$0 9 0

10 19 1

20 34 2

35 & up 3



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$0

$10

$20

$30

$40

0 1 2 3


P

Q

At each Q,

the height of

the S curveis the cost of the

marginal seller,

the seller who would

leave

the market if

the price were any

lower.

Mehmets

cost

Mustafascost

Alis cost


$0

$10

$20

$30

$40

0 1 2 3

Producer Surplus

P

Q

Producer surplus (PS): the

amount a seller

is paid for a good

minus the sellers cost

PS = P cost


These slides are incomplete unlessyou attend class

$0

$10

$20

$30

$40

0 1 2 3

Producer Surplus and the S Curve

P

Q

PS = P cost

Suppose P = $25.

Alis PS = $15

Mustafas PS = $5MehmetsPS = $0

Total PS = $20

Mustafascost

Alis cost

Total PS equals the area above

the supply curve under the

price, from 0 to Q.

Mehmetscost

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9/15

0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

PS with Lots of Sellers & a Smooth S Curve

The supply of shoes

S

1000s of pairs ofshoes

Priceper pair

Suppose P = $40.

At Q= 15(thousand), themarginal sellers cost is

$30,and her producer surplusis $10.


0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

PS with Lots of Sellers & a Smooth S Curve

The supply of shoes

S

PS is the area b/wP and the S curve, from0 to Q.

The height of this triangleis$40 15 = $25.

So,PS = x b x h

= x 25 x $25= $312.50

h


0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

How a Lower Price Reduces PS

If P falls to $30,

PS = x 15 x $15

= $112.50

Two reasons for the fall

in PS.

S

1. Fall in PSdue to sellersleaving market

2. Fall in PS due toremaining sellersgetting lower P



10/15

0

5

10

15

20

25

30

35

40

45

50

0 5 10 15 20 25

P

Q

supply curve

A. Find marginalsellers cost

at Q= 10.B. Find total PS for

P = $20.

Suppose P rises to $30.Find the increasein PS due to

C. selling 5additional units

D. getting a higher price onthe initial 10 units


Producer surplusProducer surplus



AnswersAnswers

0

5

10

15

20

25

30

35

40

45

50

0 5 10 15 20 25

P

Q

supply curve

A. At Q= 10,marginal cost = $20

B. PS = x 10 x $20= $100

P rises to $30.

C. PS onadditional units= x 5 x $10 = $25

D. Increase in PS

on initial 10 units= 10 x $10 = $10029 These slides are incomplete unless you at tend class

CS, PS, and Total Surplus

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

= buyers gains from participating in the market

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

= sellers gains from participating in the market

Total surplus = CS + PS

= total gains from trade in a market

= (value to buyers) (cost to sellers)



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The Markets Allocation of Resources

In a market economy, the allocation of resources isdecentralized, determined by the interactions of many self-interested buyers and sellers.

Is the markets allocation of resources desirable? Or would adifferent allocation of resources make society better off?

To answer this, we use total surplus as a measure of societyswell-being, and we consider whether the markets allocation isefficient.

(Policymakers also care about equality, though our focus here ison efficiency.)


Efficiency

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

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

The goods are produced by the producers with the lowest costs.

Raising or lowering the quantity of a good

would not increase total surplus.

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

surplus


Evaluating the Market EquilibriumMarket eqm:P = $30Q= 15,000

Total surplus= CS + PS

Is the market eqmefficient?

0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

S

D

CS

PS



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Which Buyers Consume the Good?

0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

S

D

Every buyerwhose WTP is $30 will buy.

Every buyerwhose WTP is< $30 will not.

So, the buyers whovalue the good most

highly are the ones

who consume it.


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 costis $30 will produce thegood.

Every seller whose costis > $30 will not.

So, the sellers with thelowest cost produce the

good.


Does Eqm 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,cost of producingthe marginal unitis $35

value to consumers

of the marginal unitis only $20

Hence, can increase totalsurplusby reducing Q.

This is true at any Qgreater

than 15.



13/15


0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

S

D

At Q= 10,cost of producingthe marginal unit

is $25value to consumersof the marginal unitis $40

Hence, can increase totalsurplusby increasing Q.

This is true at any Qless than

15.


38


0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

S

D

The market

eqm quantity

maximizes

total surplus:

At any other

quantity,

can increase

total surplus by

moving toward

the market eqm

quantity.

These slides are incomplete unless you at tend class

The market equilibrium is efficient. No other outcomeachieves higher total surplus.

Govt cannot raise total surplus by changing the markets

allocation of resources. Laissez faire (French for allow them to do):

the notion that govt should not interfere with the market.


The Free Market vs. Central Planning


14/15

The Free Market vs. Central Planning

Suppose resources were allocated not by the market, but by a

central planner who cares about societys well-being. To allocate resources efficiently and maximize total surplus,

the planner would need to know every sellers cost and everybuyers WTP for every good in the entire economy.

This is impossible, and why centrally-planned economies arenever very efficient.


CONCLUSION

These slides are incomplete unless you at tend class41

This chapter used welfare economics to demonstrate one ofthe Ten Principles:

Markets are usually a good way to organize economic

activity.

Important note:We derived these lessons assuming perfectly competitivemarkets.

In other conditions we will study in later chapters, themarket may fail to allocate resources efficiently

CONCLUSION


Such market failures occur when:

a buyer or seller has market power the ability to affect themarket price.

transactions have side effects, called externalities, that affect

bystanders. (example: pollution)

Well use welfare economics to see how public policy mayimprove on the market outcome in such cases.

Despite the possibility of market failure, the analysis in thischapter applies in many markets, and the invisible handremains extremely important.


15/15

CHAPTER SUMMARYCHAPTER SUMMARY


The height of the D curve reflects the value of the good tobuyerstheir willingness to pay for it.

Consumer surplus is the difference between what buyers arewilling to pay for a good and what they actual ly pay.

On the graph, consumer surplus is the area betweenP and the Dcurve.

The height of the S curve is sellers cost of producing the good.Sellers are willing to sell if the price they get is at least as high astheir cost.



Producer surplus is the difference between what sellersreceive for a good and their cost of producing it.

On the graph, producer surplus is the area between Pand the S curve.

To measure of societys well-being, we usetotal surplus, the sum of consumer and producersurplus.



Efficiency means that total surplus is maximized, that the goodsare produced by sellers with lowest cost, and that they areconsumed by buyers who most value them.

Under perfect competition, the market outcome is efficient.

Altering it would reduce total surplus.

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