Welfare and Efficiency
Consumer Surplus
• Welfare Economics
– How allocation of resources affect economic wellbeing
• Willingness to pay
– Maximum amount that a buyer is willing to spend
on a good (remember margins) – height of
demand curve at a quantity
• Consumer Surplus
– Willingness to pay minus amount paid
• Think of the points on a demand curve as
separate individuals
• Each person only wants one cup of coffee
• But each willing to pay a different maximum
price
• Construct a “market demand curve”
• Start with a simplified “step demand curve”
Market Demand For Coffee
Four Individuals Maximum
Willingness to Pay for Coffee
Price
Buyers
Quantity
Demanded
John
$1
>$1
None
0
Will
$0.80
$0.80-$1
John
1
Sam
$0.70
$0.70-$0.80
John, Will
2
$0.50-$0.70
Sam, John,
Will
3
$0.50 &
under
Tim, Sam,
John, Will
4
Tim
$0.50
Step Demand Curve
Price of Coffee
$1
John’s Willingness to Pay
Will’s Willingness to Pay
$0.80
Sam’s Willingness to Pay
$0.70
Tim’s Willingness to Pay
$0.50
1
2
3
4
Quantity Demanded
of Coffee
• Demand Curve
– Reflects People’s Willingness to Pay (height)
– Helps measure consumer surplus
• Consumer Surplus in a Market
– Willingness to pay minus price paid
– Graphically: Area between demand curve and
price level
Step Demand Curve
Price of Coffee
Johns Consumer
Surplus = $0.20
$1
$0.80
$0.70
$0.50
1
2
3
4
Quantity Demanded
of Coffee
Step Demand Curve
Price of Coffee
John’s Consumer
Surplus = $0.30
Will’s Consumer
Surplus = $0.10
$1
$0.80
$0.70
$0.50
Total Consumer Surplus
= $0.40
1
2
3
4
Quantity Demanded
of Coffee
• Buyers want to pay less, so lower price raises
consumer surplus
• At an initial P1, Q1 there is an initial surplus
from first buyer
• When price drops to P2 and quantity increases
to Q2
– Buyer one pays lower price
• His consumer surplus increases
– New buyer enters market
• They have a consumer surplus
Initial Consumer
Surplus
Consumer
Surplus
P1
Consumer Surplus
to new buyers
P1
P2
Additional
Consumer
Surplus to
Initial Buyers
Q1
Q1
Q2
• Consumer Surplus
– The benefit or gain buyers get from a transaction
in the market
– Measured from buyers point of view
• Measure of Welfare
– A good way to measure the economic well-being
– Way to measure benefits from a market
Producer Surplus
• Way to think of Supply Curve
– Supply Curve is willingness to accept
– Lets say this is also their cost of production
• Producer Surplus
– Amount a seller receives for a good minus the cost
of producing it
– So the price level minus the height of the supply
curve
• Again lets start with a step supply curve where
each seller sells one cup of coffee
Supply Curve for Coffee
$0.90
Alfred’s Cost of making a cup
of coffee
$0.70
Linda’s Cost of making a cup
of coffee
$0.50
Bob’s Cost of making a cup of
coffee
$0.40
Chris’s Cost of making a cup
of coffee
1
2
3
4
• Supply Curve
– Helps measure producer surplus
– Viewed as willingness to accept (price they would
take)
– Viewed as cost of production
• Producer Surplus
– Difference between price received and cost of
production
– Area between price level and supply curve
$0.90
$0.70
$0.50
$0.40
Chris’s Producer Surplus =
$0.10
1
2
3
4
$0.90
Total Producer Surplus = $0.50
$0.70
$0.50
Bob’s Producer Surplus =
$0.20
$0.40
Chris’s Producer Surplus =
$0.30
1
2
3
4
• Sellers want to get more money, so a higher
price raises producer surplus
• At an initial P1, Q1 there is an initial surplus
from first seller
• When price increases to P2 and quantity
increases to Q2
– Seller one gets higher price
• His producer surplus increases
– New seller enters market
• They have a producer surplus
Additional Producer
Surplus to first seller
Producer surplus
from new seller
P2
Producer Surplus
P1
P1
Initial Producer
Surplus from first
seller
Q1
Q1
Q2
Market Efficiency
• Maximizing the surplus in a market
– Getting the most out of the market
• Total Surplus
– Consumer surplus plus producer surplus
– Value to consumers minus cost to producers
• Efficiency vs Equality
– Efficiency
• Property of resource allocation
• An economy wide property
– Equality
• A property of how economic prosperity is distributed
• Depends on individuals
How are Markets Efficient?
• 1. Allocate the supply of goods to those who
value them the most
– Measured by willingness to pay
– Height of demand curve (higher better)
• 2. Allocate the demand for goods to producers
who can make them at the lowest cost
– Measured by willingness to accept
– Height of supply curve (lower better)
Consumer Surplus
Producer Surplus
Equilibrium and Efficiency
• Cannot Increase economic well being by:
– Changing who consumes the good (changing
allocation among buyers)
– Changing who produces the good (changing
allocation of production among sellers)
• Cannot Increase economic well being by:
– Increasing or decreasing the quantity in the
market
– So
• 3. The Free Market chooses the quantity of
good that maximizes total surplus
Buyers value good more
than the cost of
production so:
Make More
Buyers value good less
than the cost of
production so:
Make Less
Value to
Buyers
Cost to
Producers
Cost to
Producers
Value to
Buyers
Q*
• So, Equilibrium is the Efficient allocation of
resources
• Market forces guide us to this point
• Adam Smith’s ‘Invisible Hand’
• Laissez faire = allow them to do
• Conclusion
– Free market best way to organize economy
– Keep Gov’t hands off
• But, only IF
The IF’s
• Several Assumptions inherit in our conclusion
• 1. Markets are perfectly competitive
– No Market power
• 2. Decisions of buyers and sellers only affect
them and those in the market
– No Externalities
• When these are not true (market failure) our
conclusion of unregulated market leading to
best outcome may no longer be true