Principles of MicroPrinciples of Micro

Chapter 7: “Consumers, Producers, and the Chapter 7: “Consumers, Producers, and the Efficiency of Markets”Efficiency of Markets”

by Tanya Molodtsova, Fall 2005

We Will Learn:We Will Learn: the link between buyers’ the link between buyers’

willingness to pay for a good and willingness to pay for a good and the demand curvethe demand curve

how to define and measure how to define and measure consumer surplus consumer surplus

the link between sellers’ costs of the link between sellers’ costs of producing a good and the supply producing a good and the supply curve curve

how to define and measure how to define and measure producer surplus producer surplus

that the equilibrium of supply and that the equilibrium of supply and demand maximizes total surplus in demand maximizes total surplus in a market a market

Revisiting the Market Revisiting the Market EquilibriumEquilibrium Do the equilibrium price and Do the equilibrium price and

quantity maximize the total quantity maximize the total welfare of buyers and sellers?welfare of buyers and sellers?

Market equilibrium reflects the Market equilibrium reflects the way markets allocate scarce way markets allocate scarce resources.resources.

Whether the market allocation is Whether the market allocation is desirable can be addressed by desirable can be addressed by welfare economics.welfare economics.

Welfare EconomicsWelfare Economics

welfare economicswelfare economics: the : the study of how the allocation study of how the allocation of resources affects of resources affects economic well-being.economic well-being.

Buyers and sellers receive benefits Buyers and sellers receive benefits from taking part in the market. from taking part in the market.

The equilibrium in a market The equilibrium in a market maximizes the total welfare of maximizes the total welfare of buyers and sellersbuyers and sellers

Welfare EconomicsWelfare Economics Equilibrium in the market results Equilibrium in the market results

in maximum benefits, and in maximum benefits, and therefore maximum total welfare therefore maximum total welfare for both the consumers and the for both the consumers and the producers of the product.producers of the product.

Consumer surplus measures Consumer surplus measures economic welfare from the economic welfare from the buyer’s side.buyer’s side.

Producer surplus measures Producer surplus measures economic welfare from the seller’seconomic welfare from the seller’s side.side.

Consumer SurplusConsumer Surplus

willingness to paywillingness to pay: the : the maximum amount that a maximum amount that a buyer will pay for a good.buyer will pay for a good.

It measures how much the buyer It measures how much the buyer values the good or service.values the good or service.

consumer surplusconsumer surplus: a : a buyer’s willingness to buyer’s willingness to pay minus the amount pay minus the amount the buyer actually pays.the buyer actually pays.

Four Possible Buyers’ Four Possible Buyers’ Willingness to PayWillingness to Pay

Consumer SurplusConsumer Surplus The market demand curve depicts The market demand curve depicts

the various quantities that buyers the various quantities that buyers would be willing and able to would be willing and able to purchase at different prices.purchase at different prices.

The Demand Schedule and the The Demand Schedule and the Demand CurveDemand Curve

The Demand Schedule and the The Demand Schedule and the Demand CurveDemand 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 Measuring Consumer Surplus with the Demand Curvewith the Demand Curve

(a) Price = $80

Price of

Album

50

70

80

0

$100

Demand

1 2 3 4 Quantity of

Albums

John ’s consumer surplus ($20)

Measuring Consumer Surplus Measuring Consumer Surplus with the Demand Curvewith the Demand Curve

(b) Price = $70

Price of

Album

50

70

80

0

$100

Demand

1 2 3 4

Total

consumer

surplus ($40)

Quantity of

Albums

John ’s consumer surplus ($30)

Paul ’s consumer

surplus ($10)

Using Demand Curve to Using Demand Curve to Measure Consumer SurplusMeasure Consumer Surplus

The area below the demand The area below the demand curve and above the price curve and above the price measures the consumer surplus measures the consumer surplus in the market.in the market.

How the Price Affects Consumer How the Price Affects Consumer SurplusSurplus

Consumersurplus

Quantity

(a) Consumer Surplus at Price P

Price

0

Demand

P1

Q1

B

A

C

How the Price Affects Consumer How the Price Affects Consumer SurplusSurplus

Copyright©2003 Southwestern/Thomson Learning

Initialconsumer

surplus

Quantity

(b) Consumer Surplus at Price P

Price

0

Demand

A

BC

D EF

P1

Q1

P2

Q2

Consumer surplusto new consumers

Additional consumersurplus to initial consumers

What Does Consumer What Does Consumer Surplus Measure?Surplus Measure?

Consumer surplus,Consumer surplus, the amount the amount that buyers are willing to pay for a that buyers are willing to pay for a good minus the amount they good minus the amount they actually pay for it, measures the actually pay for it, measures the benefit that buyers receive from a benefit that buyers receive from a good good as the buyers themselves as the buyers themselves perceive itperceive it..

Producer SurplusProducer Surplus Producer surplusProducer surplus is the amount a is the amount a

seller is paid for a good minus the seller is paid for a good minus the seller’s cost.seller’s cost.

It measures the benefit to sellers It measures the benefit to sellers participating in a market.participating in a market.

costcost: the value of : the value of everything a seller must everything a seller must give up to produce a goodgive up to produce a good..

The Cost of Four Possible The Cost of Four Possible SellersSellers

Using Supply Curve to Using Supply Curve to Measure Producer SurplusMeasure Producer Surplus

Just as consumer surplus is Just as consumer surplus is related to the demand curve, related to the demand curve, producer surplus is closely producer surplus is closely related to the supply curve.related to the supply curve.

The Supply Schedule and the The Supply Schedule and the Supply CurveSupply Curve

The Supply Schedule and the The Supply Schedule and the Supply CurveSupply Curve

Using Supply Curve to Using Supply Curve to Measure Producer SurplusMeasure Producer Surplus

The area below the price and The area below the price and above the supply curve above the supply curve measures the producer surplus measures the producer surplus in a market.in a market.

Measuring Producer Surplus Measuring Producer Surplus with the Supply Curvewith 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 Measuring Producer Surplus with the Supply Curvewith 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 a Higher Price Raises How a Higher Price Raises Producer SurplusProducer Surplus

As price rises, producer surplus As price rises, producer surplus increases for two reasonsincreases for two reasons::

1.1. Those already selling the product Those already selling the product will receive additional producer will receive additional producer surplus because they are receiving surplus because they are receiving more for the product than before more for the product than before

2.2. Since the price is now higher, Since the price is now higher, some new sellers will enter the some new sellers will enter the market and receive producer market and receive producer surplus on these additional units surplus on these additional units of output sold of output sold

How the Price Affects Producer How the Price Affects Producer SurplusSurplus

Producersurplus

Quantity

(a) Producer Surplus at Price P

Price

0

Supply

B

A

C

Q1

P1

How the Price Affects How the Price Affects Producer SurplusProducer Surplus

Quantity

(b) Producer Surplus at Price P

Price

0

P1B

C

Supply

A

Initialproducersurplus

Q1

P2

Q2

Producer surplusto new producers

Additional producersurplus to initialproducers

D EF

Market EfficiencyMarket Efficiency Consumer surplus and producer Consumer surplus and producer

surplus may be used to address surplus may be used to address the following question:the following question: Is the allocation of resources Is the allocation of resources

determined by free markets in any determined by free markets in any way desirable?way desirable?

Consumer Surplus = Value to Buyers – Consumer Surplus = Value to Buyers – Amount Paid by BuyersAmount Paid by Buyers

Producer Surplus = Amount Received Producer Surplus = Amount Received by Sellers - Cost to Sellersby Sellers - Cost to Sellers

Market EfficiencyMarket Efficiency The economic well-being of The economic well-being of

everyone in society can be everyone in society can be measured by total surplus measured by total surplus

Total Surplus = Consumer Surplus Total Surplus = Consumer Surplus + Producer Surplus+ Producer Surplus

Total Surplus = (Value to Buyers – Total Surplus = (Value to Buyers – Amount Paid by Buyers) + Amount Paid by Buyers) +

(Amount Received by Sellers – (Amount Received by Sellers – Costs of Sellers)Costs of Sellers)

Because Amount Paid By Buyers = Because Amount Paid By Buyers = Amount Received By Sellers,Amount Received By Sellers,

Total Surplus = Total Surplus = Value to Buyers - Value to Buyers - Costs of SellersCosts of Sellers

Market EfficiencyMarket Efficiency

efficiencyefficiency: the property of a : the property of a resource allocation of resource allocation of maximizing the total surplus maximizing the total surplus received by all members of received by all members of societysociety

In addition to market efficiency, a In addition to market efficiency, a social planner might also care about social planner might also care about equityequity: the fairness of the : the fairness of the distribution of well-being distribution of well-being among the members of among the members of societysociety..

Consumer and Producer Surplus Consumer and Producer Surplus in the Market Equilibriumin the Market Equilibrium

Producersurplus

Consumersurplus

Price

0 Quantity

Equilibriumprice

Equilibriumquantity

Supply

Demand

A

C

B

D

E

Evaluating the Market Evaluating the Market EquilibriumEquilibrium

At the market equilibrium price:At the market equilibrium price: Buyers who value the product more Buyers who value the product more

than the equilibrium price will than the equilibrium price will purchase the product. In other purchase the product. In other words, the free market allocates the words, the free market allocates the supply of a good to the buyers who supply of a good to the buyers who value it most highly.value it most highly.

1.1. Sellers whose costs are less than Sellers whose costs are less than the equilibrium price will produce the equilibrium price will produce the product. In other words, the free the product. In other words, the free market allocates the demand for market allocates the demand for goods to the sellers who can goods to the sellers who can produce it at the lowest cost.produce it at the lowest cost.

Evaluating the Market Evaluating the Market EquilibriumEquilibrium Total surplus is maximized Total surplus is maximized

at the market equilibriumat the market equilibrium Free markets produce the quantity Free markets produce the quantity

of goods that maximizes the sum of goods that maximizes the sum of consumer and producer of consumer and producer surplus.surplus.

Total surplus is maximized Total surplus is maximized at the market equilibriumat the market equilibrium

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

Total surplus is maximized Total surplus is maximized at the market equilibriumat the market equilibrium

At any quantity of output smaller At any quantity of output smaller than the equilibrium quantity, the than the equilibrium quantity, the value of the product to buyers is value of the product to buyers is greater than the cost to sellers so greater than the cost to sellers so total surplus would rise if output total surplus would rise if output increasesincreases

At any quantity of output greater At any quantity of output greater than the equilibrium quantity, the than the equilibrium quantity, the value of the product to buyers is value of the product to buyers is less than the cost to sellers so total less than the cost to sellers so total surplus would rise if output surplus would rise if output decreases.decreases.

Evaluating the Market Evaluating the Market EquilibriumEquilibrium Because the equilibrium Because the equilibrium

outcome is an efficient allocation outcome is an efficient allocation of resources, the social planner of resources, the social planner can leave the market outcome can leave the market outcome as he/she finds it.as he/she finds it.

This policy of leaving well This policy of leaving well enough alone goes by the enough alone goes by the French expression French expression laissez faire.laissez faire.

Evaluating the Market Evaluating the Market EquilibriumEquilibrium To conclude that markets To conclude that markets

are efficient, we made are efficient, we made several assumptions about several assumptions about how markets worked:how markets worked:

1.1. Perfectly competitive Perfectly competitive markets.markets.

2.2. No externalities.No externalities.

Evaluating the Market Evaluating the Market EquilibriumEquilibrium Market PowerMarket Power

If a market system is not perfectly If a market system is not perfectly competitive, competitive, market powermarket power may may result.result. Market power is the ability to Market power is the ability to

influence prices.influence prices. Market power can cause markets to Market power can cause markets to

be inefficient because it keeps price be inefficient because it keeps price and quantity from the equilibrium of and quantity from the equilibrium of supply and demand.supply and demand.

Evaluating the Market Evaluating the Market EquilibriumEquilibrium ExternalitiesExternalities

created when a market outcome affects created when a market outcome affects individuals other than buyers and sellers individuals other than buyers and sellers in that market.in that market.

cause welfare in a market to depend on cause welfare in a market to depend on more than just the value to the buyers more than just the value to the buyers and cost to the sellers.and cost to the sellers.

When buyers and sellers do not take When buyers and sellers do not take externalities into account when externalities into account when deciding how much to consume and deciding how much to consume and produce, the equilibrium in the produce, the equilibrium in the market can be inefficient.market can be inefficient.

SummarySummary

Consumer surplusConsumer surplus equals buyers’ equals buyers’ willingness to pay for a good minus willingness to pay for a good minus the amount they actually pay for it.the amount they actually pay for it.

Consumer surplus measures the Consumer surplus measures the benefit buyers get from participating benefit buyers get from participating in a market.in a market.

Consumer surplus can be computed Consumer surplus can be computed by finding the area below the by finding the area below the demand curve and above the price.demand curve and above the price.

SummarySummary

Producer surplusProducer surplus equals the amount equals the amount sellers receive for their goods minus sellers receive for their goods minus their costs of production.their costs of production.

Producer surplus measures the Producer surplus measures the benefit sellers get from participating benefit sellers get from participating in a market.in a market.

Producer surplus can be computed Producer surplus can be computed by finding the area below the price by finding the area below the price and above the supply curve.and above the supply curve.

SummarySummary

An allocation of resources that An allocation of resources that maximizes the sum of consumer maximizes the sum of consumer and producer surplus is said to and producer surplus is said to be efficient.be efficient.

Policymakers are often Policymakers are often concerned with the efficiency, as concerned with the efficiency, as well as the equity, of economic well as the equity, of economic outcomes.outcomes.

SummarySummary

The equilibrium of demand and supply The equilibrium of demand and supply maximizes the sum of consumer and maximizes the sum of consumer and producer surplus.producer surplus.

This is as if the invisible hand of the This is as if the invisible hand of the marketplace leads buyers and sellers marketplace leads buyers and sellers to allocate resources efficiently.to allocate resources efficiently.

Markets do not allocate resources Markets do not allocate resources efficiently in the presence of market efficiently in the presence of market failures.failures.