Consumers, Producers, and the
Efficiency of Markets
Outline:
 Positive economics: Allocation of scarce resources
using forces of demand and supply
 Normative economics: Whether these allocations
are desirable leads to the study of welfare
economics
 Welfare economics is the study of how the
allocation of resources affects economic wellbeing
 Examine the benefits that buyers and sellers
receive from participating in the market
 Willingness to pay is the maximum amount
that a buyer will pay for a good
Consumer Surplus and Demand Curve




Consumer surplus is a buyer’s willingness to pay
minus the amount the buyer actually pays
Using the willingness to pay of the buyers one can
derive the demand schedule and the demand curve
The height of the demand curve shows the
willingness to pay of the marginal buyer
Consumer surplus in a market is measured as
the area below the demand curve and above
the market price
Consumer
Surplus
P
DD
Q
Consumer Surplus and Demand Curve

A lower price raises consumer surplus
– Existing buyers see an increase in their
consumer surplus due to a reduction in price
– New buyers enjoy consumer surplus as they can
now enter the market
Consumer surplus is a good measure of
economic well-being and respects
preferences of consumers. Is it always a
good measure?
 Important assumption in economicsconsumers are rational

Producer Surplus and Supply Curve
Cost is the value of everything a seller must
give up to produce. It includes the cost of
raw materials and the opportunity cost
(value of her time). Cost is a measure of the
seller’s willingness to sell.
 Producer surplus is the amount a seller is
paid for a good minus the seller’s cost. It
measures the benefit to the sellers for
participating in a market.
 The willingness to sell or cost is used to
derive the supply schedule and graph the
supply curve.

Producer Surplus and Supply Curve
The height of the supply curve measures the
sellers’ costs. The price on the supply curve
denotes the cost of the marginal seller
 Producer surplus in a market is the area
below the price and above the supply curve
 A higher price raises producers surplus by

– Existing producers receive a higher price
– New producers enter the market at a higher price
Market Efficiency






Consumer surplus= value to buyers- amount paid
by buyers
Producer surplus= amount received by sellers- cost
to sellers
Therefore, market surplus= value to buyers- cost to
sellers
If the allocation of resources maximizes total
surplus then that allocation is efficient
Efficiency is the property of a resource allocation
of maximizing the total surplus received by all
members of society
Equity is the fairness of the distribution of wellbeing among the members of society
Market Efficiency
Free markets allocate the supply of goods to
the buyers who value them most
 Free markets allocate the demand for goods
to the sellers who produce them at least
cost
 Free markets produce the quantity of goods
that maximizes total surplus in the market
 Conclusion: Free markets result in efficient
market outcomes but are the market
outcomes equitable?

Market Failure

Efficiency of markets is based on two major
assumptions:
– Markets are perfectly competitive
– Market outcomes matter only to the buyers and
sellers in the market
Assumptions are invalid in some cases and
result in market failure- the inability of some
unregulated markets to allocate resources
efficiently
 Causes for market failure

– Existence of market power
– Presence of externalities