Consumers, Producers, and The Efficiency of Markets

Consumers,
Producers, and the

Efficiency of Markets
Copyright 2004 South-Western
REVISITING THE MARKET

EQUILIBRIUM
Do the equilibrium price and quantity maximize
the total welfare of buyers and sellers?
Market equilibrium reflects the way markets
allocate scarce resources.
Whether the market allocation is desirable can
be addressed by welfare economics.
Welfare Economics
Welfare economics is the study of how the
allocation of resources affects economic wellbeing.

Buyers and sellers receive benefits from taking
part in the market.
The equilibrium in a market maximizes the total
welfare of buyers and sellers.
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 buyers willingness to
pay for a good minus the amount the buyer
actually pays for it.
Table 1 Four Possible Buyers Willingness to Pay
Copyright2004 South-Western
The Demand Schedule and the

Demand Curve
Figure 1 The Demand Schedule and the Demand Curve

Price of
T-Shirt
John s willingness to pay
$100
Paul s willingness to pay
80
George s willingness to pay
70
Ringo s willingness to pay
50
Demand
Quantity of
T-Shirt
Copyright2003 Southwestern/Thomson Learning
Figure 2 Measuring Consumer Surplus with the Demand

Curve
(a) Price = $80

Price of
Album
$100
John s consumer surplus ($20)
80
70
50
Demand
Quantity of
Albums
Figure 2 Measuring Consumer Surplus with the Demand

Curve
(b) Price = $70

Price of
Album
$100
John s consumer surplus ($30)
80
Paul s consumer
surplus ($10)
70
50
Total
consumer
surplus ($40)
Demand
0
4 Quantity of
Albums
Using the Demand Curve to Measure

Consumer Surplus
The area below the demand curve and above
the price measures the consumer surplus in the
market.
Figure 3 How the Price Affects Consumer Surplus

(a) Consumer Surplus at Price P
Price
A
Consumer
surplus
P1
Demand
Q1
Quantity
Figure 3 How the Price Affects Consumer Surplus

(b) Consumer Surplus at Price P
Price
A
Initial
consumer
surplus
P1
P2
C
B
Consumer surplus
to new consumers
F
D
E
Additional consumer
surplus to initial
consumers
Q1
Demand
Q2
Quantity
What Does Consumer Surplus Measure?

Consumer surplus, the amount that buyers are
willing to pay for a good minus the amount they
actually pay for it, measures the benefit that
buyers receive from a good as the buyers
themselves perceive it.
PRODUCER SURPLUS
Producer surplus is the amount a seller is paid
for a good minus the sellers cost.
It measures the benefit to sellers participating in
a market.
Table 2 The Costs of Four Possible Sellers
Copyright2004 South-Western
The Supply Schedule and the

Supply Curve
Figure 4 The Supply Schedule and the Supply Curve
Figure 5 Measuring Producer Surplus with the Supply

Curve
(a) Price = $600
Price of
House
Painting
Supply
$900
800
600
500
Grandma s producer
surplus ($100)
4
Quantity of
Houses Painted
Figure 5 Measuring Producer Surplus with the Supply

Curve
(b) Price = $800
Price of
House
Painting
$900
Supply
Total
producer
surplus ($500)
800
600
Georgia s producer
surplus ($200)
500
Grandmas producer
surplus ($300)
4
Quantity of
Houses Painted
Figure 6 How the Price Affects Producer Surplus

(a) Producer Surplus at Price P
Price
Supply
P1
B
Producer
surplus
A
0
Q1
Quantity
Figure 6 How the Price Affects Producer Surplus

(b) Producer Surplus at Price P
Price
Supply
Additional producer
surplus to initial
producers
P2
P1
E
F
B
Initial
producer
surplus
Producer surplus
to new producers
A
0
Q1
Q2
Quantity
MARKET EFFICIENCY
Consumer surplus and producer surplus may be
used to address the following question:
Is the allocation of resources determined by free
markets 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 surplus
received by all members of society.
MARKET EFFICIENCY
In addition to market efficiency, a social
planner might also care about equity the
fairness of the distribution of well-being among
the various buyers and sellers.
Figure 7 Consumer and Producer Surplus in the Market

Equilibrium
Price A
D
Supply
Consumer
surplus
Equilibrium
price
E
Producer
surplus
Demand
C
0
Equilibrium
quantity
Quantity
MARKET EFFICIENCY
Three Insights Concerning Market Outcomes
Free markets allocate the supply of goods to the
buyers who value them most highly, as measured by
their willingness to pay.
Free markets allocate the demand for goods to the
sellers who can produce them at least cost.
Free markets produce the quantity of goods that
maximizes the sum of consumer and producer
surplus.
Figure 8 The Efficiency of the Equilibrium Quantity

Price
Supply
Value
to
buyers
Cost
to
sellers
Cost
to
sellers
0
Value
to
buyers
Equilibrium
quantity
Value to buyers is greater

than cost to sellers.
Demand
Quantity
Value to buyers is less

than cost to sellers.
Evaluating the Market Equilibrium

Because the equilibrium outcome is an efficient
allocation of resources, the social planner can
leave the market outcome as he/she finds it.
This policy of leaving well enough alone goes
by 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 equilibrium of 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 take

externalities into account when deciding how
much to consume and produce, the equilibrium
in the market can be inefficient.

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Consumers, Producers, and The Efficiency of Markets

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Consumers,

Producers, and the

REVISITING THE MARKET

Copyright 2004 South-Western

allocation of resources affects economic wellbeing.

Copyright 2004 South-Western

Copyright 2004 South-Western

Copyright 2004 South-Western

Table 1 Four Possible Buyers Willingness to Pay

The Demand Schedule and the

Copyright 2004 South-Western

Figure 1 The Demand Schedule and the Demand Curve

Paul s willingness to pay

George s willingness to pay

Ringo s willingness to pay

Figure 2 Measuring Consumer Surplus with the Demand

(a) Price = $80

John s consumer surplus ($20)

Copyright2003 Southwestern/Thomson Learning

Figure 2 Measuring Consumer Surplus with the Demand

(b) Price = $70

Copyright2003 Southwestern/Thomson Learning

Using the Demand Curve to Measure

Copyright 2004 South-Western

Figure 3 How the Price Affects Consumer Surplus

Copyright2003 Southwestern/Thomson Learning

Figure 3 How the Price Affects Consumer Surplus

What Does Consumer Surplus Measure?

Copyright 2004 South-Western

Copyright 2004 South-Western

Table 2 The Costs of Four Possible Sellers

The Supply Schedule and the

Copyright 2004 South-Western

Figure 4 The Supply Schedule and the Supply Curve

Figure 5 Measuring Producer Surplus with the Supply

Figure 5 Measuring Producer Surplus with the Supply

Figure 6 How the Price Affects Producer Surplus

Figure 6 How the Price Affects Producer Surplus

Copyright 2004 South-Western

Copyright 2004 South-Western

Copyright 2004 South-Western

Copyright 2004 South-Western

Copyright 2004 South-Western

Figure 7 Consumer and Producer Surplus in the Market

Copyright 2004 South-Western

Figure 8 The Efficiency of the Equilibrium Quantity

Value to buyers is greater

Value to buyers is less

Evaluating the Market Equilibrium

Copyright 2004 South-Western

Evaluating the Market Equilibrium

Copyright 2004 South-Western

Evaluating the Market Equilibrium

When buyers and sellers do not take

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