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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.
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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
4 These slides are incomplete unless you at tend class
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
5 These slides are incomplete unless you at tend class
WTP and the Demand Curve
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)
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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
WTP and the Demand Curve
P Qd
$301 & up 0
251 300 1
176 250 2
126 175 3
0 125 4
P
Q
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$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.
8 These slides are incomplete unless you at tend class
$0
$50
$100
$150$200
$250
$300
$350
0 1 2 3 4
WTP and the Demand Curve
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
9 These slides are incomplete unless you at tend class
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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.
10 These slides are incomplete unless you at tend class
$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
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$0
$50
$100
$150
$200
$250
$300
$350
0 1 2 3 4
CS and the Demand Curve
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
CS and the Demand Curve
P
Q
The lesson:
Total CS equals the areaunder
the demand curve above
the price, from 0 to Q.
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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.
14 These slides are incomplete unless you at tend class
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
16 These slides are incomplete unless you at tend class
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
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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
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
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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.
19 These slides are incomplete unless you at tend class
Cost and the Supply Curve
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
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Cost and the Supply Curve
$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
Cost and the Supply Curve
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
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$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
23 These slides are incomplete unless you at tend class
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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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.
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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
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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
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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
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 22
Producer surplusProducer surplus
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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 22
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)
30 These slides are incomplete unless you at tend class
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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.)
31 These slides are incomplete unless you at tend class
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
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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.
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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.
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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.
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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= 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.
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38
Does Eqm Q Maximize Total Surplus?
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.
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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.
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The Free Market vs. Central Planning
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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.
40 These slides are incomplete unless you at tend class
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
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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.
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CHAPTER SUMMARYCHAPTER SUMMARY
These slides are incomplete unless you at tend class43
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.
CHAPTER SUMMARYCHAPTER SUMMARY
These slides are incomplete unless you at tend class44
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.
CHAPTER SUMMARYCHAPTER SUMMARY
These slides are incomplete unless you at tend class45
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.