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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.
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CONSUMER SURPLUS
• Willingness to pay (WTP) is the maximum
amount that a buyer will pay for a good.
• It measures how much the buyer values the
good or service.
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CONSUMER SURPLUS
• Consumer surplus is
– the buyer’s willingness to pay for a good minus
– the amount the buyer actually pays for it.
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Figure 3 How the Price Affects Consumer Surplus
(a) Consumer Surplus at Price P
Price
A
Consumer
surplus
P1
B
C
Demand
0
Q1
Quantity
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Figure 3 How the Price Affects Consumer Surplus
(b) Consumer Surplus at Price P
Price
A
Initial
consumer
surplus
P1
P2
0
C
B
Consumer surplus
to new consumers
F
D
E
Additional consumer
surplus to initial
consumers
Q1
Demand
Q2
Quantity
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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.
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ACTIVE LEARNING
Consumer surplus
1:
P
50
$ 45
A. Find marginal
buyer’s WTP at
40
Q = 10.
35
B. Find CS for
30
P = $30.
25
Suppose P falls to $20. 20
How much will CS
15
increase due to…
10
C. buyers entering
5
the market
0
D. existing buyers
0
paying lower price
Demand curve
5
10
15
20
Q
25
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ACTIVE LEARNING
Answers
1:
P
50
$ 45
A. At Q = 10, marginal
buyer’s WTP is $30. 40
35
B. CS = ½ x 10 x $10
30
= $50
25
P falls to $20.
20
C. CS for the
15
additional buyers
10
= ½ x 10 x $10 = $50
5
D. Increase in CS
0
on initial 10 units
0
= 10 x $10 = $100
Demand curve
5
10
15
20
Q
25
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PRODUCER SURPLUS
• Producer surplus is the amount a seller is paid
for a good minus the seller’s cost.
– Cost here includes opportunity cost
• All out of pocket costs plus time costs
• It measures the benefit to sellers participating
in a market.
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Figure 6 How the Price Affects Producer Surplus
(a) Producer Surplus at Price P
Price
Supply
P1
B
Producer
surplus
C
A
0
Q1
Quantity
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Figure 6 How the Price Affects Producer Surplus
(b) Producer Surplus at Price P
Price
Supply
Additional producer
surplus to initial
producers
P2
P1
D
E
F
B
Initial
producer
surplus
C
Producer surplus
to new producers
A
0
Q1
Q2
Quantity
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ACTIVE LEARNING
2:
Supply curve
Producer Surplus
P
50
A. Find marginal
45
seller’s cost
40
at Q = 10.
35
B. Find PS for
30
P = $20.
25
Suppose P rises to $30. 20
Find the increase
15
in PS due to…
10
C. selling 5
5
additional units
0
D. getting a higher price
0
on the initial 10 units
5
10
15
20
Q
25
© 2011 Thomson South-Western
ACTIVE LEARNING
Answers
A. At Q = 10,
marginal cost = $20
B. PS = ½ x 10 x $20
= $100
P rises to $30.
C. PS on
additional units
= ½ x 5 x $10 = $25
D. Increase in PS
on initial 10 units
= 10 x $10 = $100
2:
Supply curve
P
50
45
40
35
30
25
20
15
10
5
0
0
5
10
15
20
Q
25
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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?
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The Benevolent Social Planner
Consumer Surplus
= Value to buyers – Amount paid by buyers
and
Producer Surplus
= Amount received by sellers – Cost to sellers
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The Benevolent Social Planner
Total surplus
= Consumer surplus + Producer surplus
= (value to buyers) – (amount paid by buyers)
+ (amount received by sellers) – (cost to sellers)
= (value to buyers) – (cost to sellers)
Total surplus
= Value to buyers – Cost to sellers
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The Benevolent Social Planner
• Efficiency is the property of a resource
allocation of maximizing the total surplus
received by all members of society.
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The Benevolent Social Planner
• 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.
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Figure 7 Consumer and Producer Surplus in the Market Equilibrium
Price A
D
Supply
Consumer
surplus
Equilibrium
price
E
Producer
surplus
B
Demand
C
0
Equilibrium
quantity
Quantity
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Evaluating the Market Equilibrium
• 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.
© 2011 Thomson South-Western
Which Buyers Get to Consume the Good?
Every buyer
whose WTP is
≥ $30 will buy.
P
60
S
50
Every buyer
whose WTP is
< $30 will not.
40
So, the buyers who
value the good most
highly are the ones
who consume it.
20
30
10
D
Q
0
0
5 10 15 20 25 30
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Which Sellers Produce the Good?
Every seller whose
cost is ≤ $30 will
produce the good.
Every seller whose
cost is > $30 will
not.
Hence, the sellers
with the lowest cost
produce the good.
P
60
S
50
40
30
20
10
D
Q
0
0
5 10 15 20 25 30
© 2011 Thomson South-Western
Does Eq’m Q Maximize Total Surplus?
At Q = 20,
cost of producing
the marginal unit
is $35
value to consumers
of the marginal unit
is only $20
Hence, can increase
total surplus
by reducing Q.
This is true at any Q
greater than 15.
P
60
S
50
40
30
20
10
D
Q
0
0
5 10 15 20 25 30
© 2011 Thomson South-Western
Does Eq’m Q Maximize Total Surplus?
At Q = 10,
cost of producing
the marginal unit
is $25
P
60
S
50
value to consumers
of the marginal unit
is $40
40
Hence, can increase
total surplus
by increasing Q.
20
This is true at any Q
less than 15.
0
30
10
D
Q
0
5 10 15 20 25 30
© 2011 Thomson South-Western
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.
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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.
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