Chapter 7
Consumers, Producers and
the Efficiency of Markets
Harcourt Brace & Company
Market Equilibrium Revisited
Does the equilibrium price and quantity result in
the maximum total welfare of buyer and seller?
S
PE
D
Harcourt Brace & Company
QE
Market Equilibrium Revisited
Does the equilibrium price and quantity result in
the maximum total welfare of buyer and seller?
Market
equilibrium illustrates the way
markets allocate scarce resources.
But does it answer whether that market
allocation is desirable?
We can turn to Welfare Economics to
answer the question.
Harcourt Brace & Company
Welfare Economics
Welfare
economics is the study of how
the allocation of resources affects
economic well being.
– Buyers and sellers receive benefits from
taking part in the market.
– The equilibrium in a market makes the
sum of these benefits as large as
possible.
Harcourt Brace & Company
Welfare Economics
Equilibrium
in the market results in
maximum benefits, and therefore total
welfare for both the buyer and the
seller.
Welfare Economics from the Buyer
Side and the Seller Side:
– Consumer Surplus
– Producer Surplus
Harcourt Brace & Company
Welfare Economics: Consumer Surplus
Market
Demand Curve: depicts the
various quantities that buyers would
want to purchase at different prices.
What determines how much a
consumer would be willing to pay (the
maximum price) for a good or service?
– Answer: The expected benefits received
or Utility.
Harcourt Brace & Company
Utility is...
… the satisfaction
(benefit) that a
consumer expects to
receive from
consuming a good or
service.
…the power to satisfy
a want.
Harcourt Brace & Company
Marginal Utility (MU) is...
…the amount of utility (satisfaction)
that one more unit of consumption
adds to total utility.
– Consumers try to obtain the largest
possible total satisfaction (utility) from
the mix of goods and services they buy
with their incomes.
Harcourt Brace & Company
Consumer Surplus is...
…the maximum amount a consumer
will be willing to pay for a good
depends upon the expected utility
(benefits) of that good.
– Willingness to Pay:
The
maximum price that a buyer is willing
and able to pay for a good.
Measures how much the buyer values the
good or service.
Harcourt Brace & Company
Consumer Surplus: Verbal Definition
 The
amount a buyer
is willing to pay for a
good minus the
amount the buyer
actually pays for it.
D
Harcourt Brace & Company
Consumer Surplus: Graphical
S
Pmax
PE
D
Harcourt Brace & Company
QE
Consumer Surplus: Graphical
S
Pmax
Consumer
Surplus
PE
D
Harcourt Brace & Company
QE
Consumer Surplus and Market Price
The
area below the demand curve and
above the market price measures the
consumer surplus in a market. Hence,
– A lower market price will increase
consumer surplus
– A higher market price will reduce
consumer surplus
Harcourt Brace & Company
$11
CONSUMER
SURPLUS
$10
$9
$8
Consumers
Expense
$7
$6
D
1
Harcourt Brace & Company
2
3
4
5
6
Producer Surplus
Market
Supply Revisited:
– Depicts the various quantities that
suppliers would be willing to sell at
different prices.
– May be viewed as a measure of supplier
costs, i.e.. the opportunity cost to the
seller of supplying various quantities of
the good.
Harcourt Brace & Company
Producer Surplus: Verbal Definition
 The
amount a seller is
paid minus the cost
of production.
 Producer surplus
measures the benefit
to sellers of
participating in a
market.
Harcourt Brace & Company
S
Producer Surplus: Graphical
S
PE
D
Harcourt Brace & Company
QE
Producer Surplus: Graphical
S
PE
Producer
Surplus
D
Harcourt Brace & Company
QE
Producer
Surplus
S
$6
$5
$4
Producer
Costs
$3
$2
$1
1
Harcourt Brace & Company
2
3
4
5
6
Market Efficiency
Under
the assumptions of perfect
competition and no externalities, the
economic well-being of a society is
measured as the sum of consumer
surplus and producer surplus.
Market Efficiency is attained when total
surplus is maximized, a point where
resource allocation is efficient.
Harcourt Brace & Company
Market Efficiency
S
PE
D
Harcourt Brace & Company
Market Efficiency
Consumer
Surplus
S
PE
Producer
Surplus
Harcourt Brace & Company
D
Market Efficiency: Three observations
Free
markets allocate the supply of
goods to the buyers who value them
most highly.
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.
Harcourt Brace & Company
Market Efficiency: Invisible Hand
 In
a free market system the many buyers
and sellers are interested in their own
well-being, self-interest.
 As market participants are motivated by
self-interest a process of coordination
and communication takes place so that
buyers and sellers are directed to the
most efficient outcome.
 As if by an Invisible Hand, the free
market system reaches efficiency.
Harcourt Brace & Company
Market Failure
If
a market system affects individuals
other than buyers and sellers of that
market, side-effects are created and
called Externalities.
– Benefits or costs imposed on a third party
who is not the consumer or the producer.
Externalities
cause markets to be
inefficient, and thus fail.
Harcourt Brace & Company