Chapter

7
Consumers, Producers, and the Efficiency of Markets

Consumer Surplus
Welfare economics
How the allocation of resources affects economic well-being

Willingness to pay
Maximum amount that a buyer will pay for a good

Consumer surplus
Amount a buyer is willing to pay for a good Minus amount the buyer actually pays for it
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Table

Four possible buyers willingness to pay

Buyer John Paul George Ringo Willingness to pay $100 80 70 50

Consumer Surplus
Using the demand curve to measure consumer surplus
Consumer surplus
Closely related to the demand curve

Demand schedule
Derived from the willingness to pay of the possible buyers

At any quantity
Price given by the demand curve
Willingness to pay of the marginal buyer
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Figure 1 The demand schedule

Price More than $100 $80 to $100 $70 to $80 $50 to $70 $50 or less

Buyers None John John, Paul John, Paul, George John, Paul, George, Ringo

Quantity Demanded 0 1 2 3 4

The table shows the demand schedule for the buyers in Table 1.

Figure 1 The demand curve

Price of Albums
Johns willingness to pay

$100
80 70 50

Pauls willingness to pay Georges willingness to pay

Ringos willingness to pay

Demand 0 1 2 3 Quantity of Albums 4

The graph shows the corresponding demand curve. Note that the height of the demand curve reflects buyers willingness to pay

Consumer Surplus
Using the demand curve to measure consumer surplus Demand curve
Reflects buyers willingness to pay Measure consumer surplus

Consumer surplus in a market

Area below the demand curve and above the price
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Figure 2 Measuring consumer surplus with the demand curve

Price of Albums $100
80 70 50 (a) Price = $80 Price of Albums $100 80 70 50
Total consumer surplus ($40)

(b) Price = $70

Johns consumer surplus ($30)

Johns consumer surplus ($20)

Pauls consumer surplus ($10)

Demand 0 1 2 3 4 Quantity of Albums

Demand

2 3 4 Quantity of Albums

In panel (a), the price of the good is $80, and the consumer surplus is $20. In panel (b), the price of the good is $70, and the consumer surplus is $40.

Consumer Surplus
How a lower price raises consumer surplus Buyers - always want to pay less
Initial price, P1
Quantity demanded Q1 Given consumer surplus

New, lower price, P2

Greater quantity demanded, Q2
New buyers

Increase in consumer surplus

From initial buyers From new buyers
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Figure 3 How the price affects consumer surplus

(a) Consumer surplus at price P1 Price A Price A (b) Consumer surplus at price P2

Consumer surplus

P1 B

P1 P2 Demand

Initial consumer surplus

Additional consumer surplus to initial consumers

C F

B D E

Consumer surplus to new consumers

Demand

Q1

Quantity

Q1

Q2

Quantity

In panel (a), the price is P1, the quantity demanded is Q1, and consumer surplus equals the area of the triangle ABC. When the price falls from P1 to P2, as in panel (b), the quantity demanded rises from Q1 to Q2, and the consumer surplus rises to the area of the triangle ADF. The increase in consumer surplus (area BCFD) occurs in part because existing consumers now pay less (area 10 BCED) and in part because new consumers enter the market at the lower price (area CEF).

Consumer Surplus
What does consumer surplus measure? Consumer surplus
Benefit that buyers receive from a good
As the buyers themselves perceive it

Good measure of economic well-being Exception: Illegal drugs

Drug addicts
Willing to pay a high price for heroin

Societys standpoint
Drug addicts dont get a large benefit from being able to buy heroin at a low price 11

Producer Surplus
Cost and the willingness to sell Cost
Value of everything a seller must give up to produce a good

Producer surplus
Amount a seller is paid for a good Minus the sellers cost of providing it

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Table

The costs of four possible sellers

Seller Mary Frida Georgia Grandma Willingness to pay $900 800 600 500

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Producer Surplus
Using the supply curve to measure producer surplus
Producer surplus
Closely related to the supply curve

Supply schedule
Derived from the costs of the suppliers

At any quantity
Price given by the supply curve
Cost of the marginal seller
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Figure 4 The supply schedule

Price $900 or more $800 to $900 $600 to $800 $500 to $600 Less than $500

Sellers Mary, Frida, Georgia, Grandma Frida, Georgia, Grandma Georgia, Grandma Grandma None

Quantity Supplied 4 3 2 1 0

The table shows the supply schedule for the sellers in Table 2.

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Figure 4 The supply curve

Price of House Painting
$900 800 600 500 Supply
Marys cost
Fridas cost Georgias cost Grandmas cost

2 3 4 Quantity of Houses Painted

The graph shows the corresponding supply curve. Note that the height of the supply curve reflects sellers costs.

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Producer Surplus
Using the supply curve to measure producer surplus Supply curve
Reflects sellers costs Measure producer surplus

Producer surplus in a market

Area below the price and above the supply curve
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Figure 5 Measuring producer surplus with the supply curve

Price of House Painting $900 800 600 500 (a) Price = $600 Supply Price of House Painting $900 800 600 500 (b) Price = $800 Supply
Total producer surplus ($500)

Grandmas producer surplus ($100)

Georgias producer surplus ($200) Grandmas producer surplus ($300)

1 2 3 4 Quantity of Houses Painted

1 2 3 4 Quantity of Houses Painted

In panel (a), the price of the good is $600, and the producer surplus is $100. In panel (b), the price of the good is $800, and the producer surplus is $500.

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Producer Surplus
How a higher price raises producer surplus Sellers - want to receive a higher price
Initial price, P1
Quantity supplied, Q1 Given producer surplus

New, higher price, P2

Greater quantity supplied, Q2
New producers

Increase in producer surplus

From initial suppliers From new suppliers
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Figure 6 How the price affects producer surplus

(a) Producer surplus at price P1 Price Supply Price
Additional producer surplus to initial producers

(b) Producer surplus at price P2 Supply E F

P2
P1

D B
Initial consumer surplus

B
Producer surplus

P1

Producer surplus to new producers

A
0 Q1

Quantity

Q1

Q2 Quantity

In panel (a), the price is P1, the quantity supplied is Q1, and producer surplus equals the area of the triangle ABC. When the price rises from P1 to P2, as in panel (b), the quantity supplied rises from Q1 to Q2, and the producer surplus rises to the area of the triangle ADF. The increase in producer surplus (area BCFD) occurs in part because existing producers now receive more(area BCED) and 20 in part because new producers enter the market at the higher price (area CEF).

Market Efficiency
The benevolent social planner
All-knowing, all-powerful, well-intentioned dictator Wants to maximize the economic well-being of everyone in society

Economic well-being of a society

Total surplus = Sum of consumer and producer surplus

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Market Efficiency
The benevolent social planner
Total surplus = Consumer surplus + Producer surplus
Consumer surplus = Value to buyers Amount paid by buyers Producer surplus = Amount received by sellers Cost to sellers Amount paid by buyers = Amount received by sellers

Total surplus = Value to buyers Cost to sellers

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Market Efficiency
Efficiency
Property of a resource allocation Maximizing the total surplus
Received by all members of society

Equality
Property of distributing economic prosperity Uniformly among the members of society

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Market Efficiency
Evaluating the market equilibrium Market outcomes
1. Free markets allocate the supply of goods to the buyers who value them most highly
Measured by their willingness to pay

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

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Figure 7 Consumer and producer surplus in the market equilibrium

Price
A

Supply
D

Equilibrium price

Consumer surplus

E
Producer surplus B C

Demand

Equilibrium Quantity quantity Total surplusthe sum of consumer and producer surplusis the area between the supply and demand curves up to the equilibrium quantity 25

Market Efficiency
Evaluating the market equilibrium
Social planner
Cannot increase economic well-being by
Changing the allocation of consumption among buyers Changing the allocation of production among sellers

Cannot rise total economic well-being by

Increasing or decreasing the quantity of the good

3. Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus
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Figure 8 The efficiency of the equilibrium quantity

Price Supply

Value to buyers

Cost to sellers Demand

Cost to sellers 0

Value to buyers

Q1

Equilibrium quantity

Q2

Quantity

Value to buyers is greater than cost to sellers

Value to buyers is less than cost to sellers

At quantities less than the equilibrium quantity, such as Q1, the value to buyers exceeds the cost to sellers. At quantities greater than the equilibrium quantity, such as Q2, the cost to sellers exceeds the value to buyers. Therefore, the market equilibrium maximizes the sum of producer and 27 consumer surplus.

Market Efficiency
Evaluating the market equilibrium Equilibrium outcome
Efficient allocation of resources

The benevolent social planner

Can leave the market outcome just as he finds it Laissez faire = allow them to do

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Market Efficiency
Evaluating the market equilibrium Adam Smiths invisible hand
Takes all the information about buyers and sellers into account Guides everyone in the market to the best outcome
Economic efficiency

Free markets = best way to organize economic activity

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Should there be a market in organs? How a mothers love helped save two lives
Ms. Stevens - her son needed a kidney transplant The mothers kidney was not compatible Donated one of her kidneys to a stranger Her son move to the top of the kidney waiting list

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Should there be a market in organs? Questions

Trade a kidney for a kidney Trade a kidney for an expensive, experimental cancer treatment? Exchange her kidney for free tuition for her son? Sell her kidney for cash?

Public policy
Illegal for people to sell their organs

Market for organs

Government has imposed a price ceiling of zero
Shortage of the good
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Should there be a market in organs? Large benefits to allowing a free market in organs
People are born with two kidneys
Usually need only one

Few people no working kidney

Current situation
Typical patient - wait several years for a kidney transplant Every year - thousands of people die because a kidney cannot be found
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Should there be a market in organs? Allow for kidney market

Balance supply and demand
Sellers - extra cash in their pockets Buyers live No more shortage of kidneys Efficient allocation of resources

Critics: worry about fairness

Benefit the rich at the expense of the poor

Current system: is it fair?

Some people - extra kidney they dont really need Others - dying to get one
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Market Efficiency & Market Failure

Forces of supply and demand allocate resources efficiently
Several assumptions about how markets work
1. Markets are perfectly competitive 2. Outcome in a market matters only to the buyers and sellers in that market

When these assumptions do not hold

Our conclusion that the market equilibrium is efficient may no longer be true
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Market Efficiency & Market Failure

In the world
Competition - far from perfect
Market power
A single buyer or seller (small group) Control market prices Markets are inefficient
Keeps the price and quantity away from the equilibrium of supply and demand

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Market Efficiency & Market Failure

In the world
Decisions of buyers and sellers
Affect people who are not participants in the market at all Externalities
Cause welfare in a market to depend on more than just the value to the buyers and the cost to the sellers

Inefficient equilibrium
From the standpoint of society as a whole

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Market Efficiency & Market Failure

Market failure
E.g.: market power and externalities The inability of some unregulated markets to allocate resources efficiently Public policy
Can potentially remedy the problem Increase economic efficiency

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