Consumers, Producers and
Market Efficiency
Lecture 5 – academic year 2014/15
Introduction to Economics
Fabio Landini
Where are we…
• Lecture 1 : Demand and supply model
• Lecture 2: Elasticity and its application
• Lecture 4: Demand, Supply and economic
policy
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What do we do today?
• Allocative efficiency: – how do we measure
the welfare of both consumers and
producers?
• Consumer surplus
• Producer surplus
• THE INVISIBLE HAND THEOREM
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QUICK QUIZ
If the equilibrium price on the market for
cigarettes is equal to 10 Euro a pack, and
Government introduces a MAXIMUM price
equal to 12 Euro, we obtain…
A) … Excess supply: the quantity supplied is
greater than the quantity demanded.
B) ... Scarcity: the quantity demanded is greater
than the quantity supplied.
C) ... No effect on the market.
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Premise: What’s an auction?
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Two issues
1. Is there a RIGHT price?
• Consumers: prices are ALWAYS too high;
• Producers: prices are ALWAYS too low.
How do we understand which is the ‘right’ price?
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Two issues
2. Is the MARKET EQUILIBRIUM (that is: p & q)
right?
• So far: positive analysis of the market;
• Now: normative analysis;
• We ask: Is the resource allocation
produced by the market desirable? In
which sense?
• How do we measure welfare?
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Welfare measure
The consumer surplus measures the
benefit that the consumer obtains from
participating to the market.
The producer surplus measures the same
benefit for the producer.
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Consumer surplus
Willingness to pay: it is the maximum
amount that the consumer is willing to pay
to obtain the good.
It measures the value that the consumer
attaches to the good or service.
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Consumer surplus
The demand curve describes the quantity
that consumers are willing to buy at different
prices.
The consumer surplus is the difference
between the consumer’s willingness to pay
and the price that is effectively paid.
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Example: willingness to pay for a rare
Elvis’s record?
Consumer
Willingness to pay
John
100
Paul
80
George
70
Ringo
50
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Summary: demand table
Price
Consumers
Quantity
Demanded
>100
None
0
80 -100
John
1
70 - 80
John, Paul
2
50 - 70
John, Paul, George
3
< 50
John, Paul, George, Ringo
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Consumer surplus and
demand curve – Price=80
Price
100
Consumer surplus John (20 euro)
80
70
50
0
1
2
3
4
Quantity
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Consumer surplus and
demand curve – Price=70
Price
100
Consumer surplus John (30 euro)
80
70
50
0
Consumer surplus Paul (10 euro)
Total consumer surplus
(40 euro)
1
2
3
4
Quantity
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Consumer surplus and
demand curve – Price=70
Price
100
Consumer surplus John (30 euro)
80
70
50
Consumer surplus Paul (10 euro)
Total consumer surplus
(40 euro)
Domanda
0
1
2
3
4
Quantity
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Consumer surplus and price
Consumer surplus = area in between the
demand curve and the price level.
There exist a negative relationship between
price and consumer surplus.
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Effects of price variations
on consumer surplus
Price
P1
A
B
Surplus of
initial
consumer
C
Demand
0
Q1
Quantity
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Effects of price variations
on consumer surplus
Price
P1
A
B
P2
Surplus of
initial
consumer
C
F
D
Demand
0
Q1
Q2
Quantity
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Effects of price variations
on consumer surplus
Price
P1
A
B
P2
Surplus of
initial
consumer
Surplus for the
new consumer
C
F
E
D
Additional surplus for
the initial consumer
Demand
0
Q1
Q2
Quantity
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Producer surplus
Supply curve
• It describes the quantity that the producers
are willing to sell for each price;
• The willingness to sell is determined by the
costs of production (measured as an
opportunity cost);
• As the market price increases, less efficient
producers can enter the market
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Producer surplus
The producer surplus is the difference
between the price paid by the consumer and
the cost of production.
It measures the benefit that the producer
obtains from participating to the market.
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Example: willingness to sell a rare Elvis’s
record?
Producer
Costs
Mick
900
Keith
800
Charli
600
Bill
500
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Summary: Table of supply
Price
Sellers
Quantity
supplied
P > 900
Bill, Charlie, Keith e
Mick
4
800 -900
Bill, Charlie, Keith
3
600 -800
Bill, Charlie
2
500 - 600
Bill
1
None
0
P < 500
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To measure the producer surplus with the
supply curve
Price
900
800
600
500
Bill’s surplus (100 euro) if p=600
0
1
2
3
Quantity
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To measure the producer surplus with the
supply curve
Price
Total producer surplus (500
euro)
900
800
Charlie’s surplus
(200 euro) if p=800
600
500
Bill’s surplus (300 euro) if p=800
0
1
2
3
Quantity
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To measure the producer surplus with the
supply curve
Price
Total producer surplus (500
euro)
Supply
900
800
Charlie’s surplus
(200 euro) if p=800
600
500
Bill’s surplus (300 euro) if p=800
0
1
2
3
Quantity
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Effects of price variations
on producer surplus
Price
Supply
P1
B
Surplus of
initial
producer
C
A
0
Q1
Q2
Quantity
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Effects of price variations
on producer surplus
Price
Supply
P2
P1
B
Surplus of
initial
producer
C
A
0
Q1
Q2
Quantity
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Effects of price variations
on producer surplus
Price
Supply
Additional surplus for
initial producer
P2
P1
D
B
Surplus of
initial
producer
F
C
Surplus for the
new producer
A
0
Q1
Q2
Quantity
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Market efficiency
In a market with perfect competition and
no externalities:
• Social welfare = consumer surplus +
producer surplus
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Consumer surplus and producer surplus
in equilibrium
Price
A
D
Equilibrium
price
Supply
E
B
Demand
C
0
Equilibrium
quantity
Quantity
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Consumer surplus and producer surplus
in equilibrium
Price
A
D
Equilibrium
price
Supply
E
Producer
surplus
B
Demand
C
0
Equilibrium
quantity
Quantity
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Consumer surplus and producer surplus
in equilibrium
Price
A
D
Supply
Consumer
surplus
Equilibrium
price
E
Producer
surplus
B
Demand
C
0
Equilibrium
quantity
Quantity
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Allocative efficiency
Allocative efficiency obtains when the
allocation of resources maximizes total surplus.
Does a perfectly competitive market achieve
allocative efficiency?
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Market equilibrium and
allocative efficiency
In a free market:
• The supply of a good goes to those consumers
that evaluate the good the most.
• The demand of a good is satisfied by the
sellers that con produce the good at the
lowest cost.
• The quantity of good that maximizes the sum
of consumer surplus and producer surplus is
finally produced.
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Graphical demonstration
Price
Supply
Value
for the
consum
er
Cost
for the
producer
Cost
for the
producer
0
Equilibrium
quantity
The value for the consumer
is greater than the cost
for the producer.
Value
for the
consum
er
The value for the consumer
is lower than the cost
for the producer.
Demand
Quantity
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The invisible hand
In a free market there exist several producers and
consumers, each motivated by her own selfinterest.
Thanks to the price system (= impersonal
coordination and communication device):
• Individual decisions of producers and consumers
leads to an efficient allocation of resources.
This is the INVISIBLE HAND THEOREM.
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Does the invisible hand theorem
always hold?
No, in two cases at least:
1. Market power;
2. Externalities.
In these cases we usually talk about MARKET
FAILURES.
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Market power
• Market power= when consumers or producers
have some control over market prices – we
talk about “imperfect competition” (monopoly,
oligopoly).
• Market power generates inefficiencies
(=“market failures”), because market prices do
not reflect social cost of resources.
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Externalities
Externalities: when the decisions of consumers
and producers have “external effects”, i.e. effects
(both costs and benefits) on individuals that do
not participate to the market.
Externalities generate inefficiencies (= “market
failures”), because market prices do not reflect
the social cost of resources.
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Welfare
Consumer surplus and producer surplus measure
the benefits that consumers and producers can
derive from participating to the market
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Efficiency
An allocation of resources that maximizes the
total surplus (= consumer surplus + producer
surplus) is called “efficient”
The existence of market power and externalities
can lead to inefficient results and market
failures
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Conclusions
Keep in mind: social welfare is not only
efficiency, but also equity!
We will talk about that later in the course….
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Next week
Economic policy and efficiency:
exercises and applications
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