Lecture Notes: Econ 203 Introductory Microeconomics
Lecture/Chapter 7: Welfare economics/efficiency of markets
M. Cary Leahey
Manhattan College
Fall 2012
Goals
• Introduction of welfare economics, how the allocation of resources
affects economic well-being
• Introduce useful policy concepts:
•
consumer surplus
•
producer surplus
•
willingness to pay
•
when the govt can help/hurt market outcomes
2
Well being of consumers-willingness to pay
• Willingness to pay (WTP) is how much a buyer is the maximum
amount a buyer is willing to pay for a good or service
• WTP is a direct measure of consumer valuation
• A demand curve can be derived by determining the WTP of each
individual in the survey (next slide)
• Moving perfectly along this WTP is the goal of every supplier, as we
will be when we study monopoly pricing
3
WTP and the demand curve, as the number of number increases the
“staircase” becomes a smooth curve
P
$350
$300
P
Qd
$250
$200
$301 & up
0
251 – 300
1
$150
176 – 250
2
$100
$50
126 – 175
3
0 – 125
4
$0
Q
0
1
2
3
4
Consumer surplus (CS)
Consumer surplus is the amount a buyer is willing to pay minus the
amount the buyer actually pays:
CS = WTP – P
name
Anthony
WTP
$250
Suppose P = $260.
Flea’s CS = $300 – 260 = $40.
Chad
175
Flea
300
The others get no CS because
they do not buy an iPod at this
price.
John
125
Total CS = $40.
Consumer surplus and the “staircase” demand curve
P
Flea’s WTP
$350
$300
Anthony’s WTP
$250
$200
Instead, suppose
P = $220
Flea’s CS =
$300 – 220 = $80
Anthony’s CS =
$250 – 220 = $30
$150
Total CS = $110
$100
$50
$0
Q
0
1
2
3
4
How a higher price reduces consumer surplus
If P rises to $40,
CS = ½ x 10 x
$20
= $100.
Two reasons for
the fall in CS.
2. Fall in CS due to
remaining buyers
paying higher P
P
60
50
1. Fall in CS
due to buyers
leaving market
40
30
20
10
D
Q
0
0
5 10 15 20 25 30
Cost and the supply curve (producers surplus)
• Cost is the value of everything (all-in) the producer must give up to
produce a good (opportunity cost)
• Includes all resource costs of input, including the opportunity cost of
the seller’s time
• See chart of a stepwise supply curve
8
Cost and the supply curve
P
P
$40
Qs
$0 – 9
0
10 – 19
1
$20
20 – 34
2
$10
35 & up
3
$30
$0
Q
0
1
2
3
Producer surplus
PS = P – cost
P
$40
Producer surplus (PS):
the amount a seller
is paid for a good
minus the seller’s cost
$30
$20
$10
$0
Q
0
1
2
3
Producer surplus and the S curve
PS = P – cost
P
$40
Chrissy’s
cost
$30
Janet’s
cost
$20
Jack’s cost
$10
$0
Q
0
1
2
3
Suppose P = $25.
Jack’s PS = $15
Janet’s PS = $5
Chrissy’s PS = $0
Total PS = $20
Total PS equals the
area above the supply
curve under the price,
from 0 to Q.
Producer surplus with lots of sellers and a smooth S curve
PS is the area b/w
P and the S curve, from 0
to Q.
60
The height of this triangle is
$40 – 15 = $25.
50
So,
PS = ½ x b x h
= ½ x 25 x $25
= $312.50
P
The supply of shoes
S
40
30
h
20
10
Q
0
0
5 10 15 20 25 30
How a lower price reduces producer surplus
If P falls to $30,
P
PS = ½ x 15 x $15
= $112.50
60
Two reasons for the fall in
PS.
50
1. Fall in PS
due to sellers
leaving market
S
40
30
2. Fall in PS due to
remaining sellers
getting lower P
20
10
Q
0
0
5 10 15 20 25 30
Total surplus = consumer plus producer surplus
• Consumer surplus is the value to buyers
•
The buyers gains from participating in the market
• Producer surplus is the value to seller = amount received less costs
•
The sellers gain from participating in the market.
• Total surplus = CS + PS
•
Total gains from trade
•
Value to buyers – cost to sellers
14
Market allocation of resources – efficiency versus equity
• In the market economy, allocation of resources is conducted by
decentralized atomistic buyers and sellers
• Is the market outcome desirable? Would another be better?
• The economist’s answer is to look at the total surplus as a measure
of societal well-being to see if the result is efficient. The question of
equity is usually reserved fro another day.
15
Efficiency
• The market allocation is efficient if it maximizes total surplus
•
Goods are consumed by the buyers who value them most highly
(movement down the demand curve).
•
Goods are produced by the producers with the lowest costs
(movement up the supply curve).
• Changing quantity would not increase total surplus.
16
Evaluating the market equilibrium
P
Market equilibrium:
P = $30
Q = 15,000
Total surplus
= CS + PS
Is the market equilibrium
efficient?
60
S
50
40
CS
30
PS
20
10
D
Q
0
0
5 10 15 20 25 30
Which buyers consume the good?
Every buyer
whose WTP is
≥ $30 will buy.
Every buyer
whose WTP is
< $30 will not.
So, the buyers who
value the good most
highly are the ones who
consume it.
P
60
S
50
40
30
20
10
D
Q
0
0
5 10 15 20 25 30
Which sellers produce the good?
Every seller whose cost is
≤ $30 will produce the
good.
Every seller whose cost is
> $30 will not.
So, 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
Does equilibrium 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
Does equilibrium Q maximize total surplus?
At Q = 10,
cost of producing
the marginal unit
is $25
value to consumers
of the marginal unit
is $40
Hence, can increase total
surplus
by increasing Q.
This is true at any Q less
than 15.
P
60
S
50
40
30
20
10
D
Q
0
0
5 10 15 20 25 30
Does equilibrium Q maximize total surplus—invisible hand?
P
The market
equilibrium quantity
maximizes
total surplus:
At any other quantity,
can increase
total surplus by moving
toward
the market equilibrium
quantity.
This is Adam Smith’s
“invisible hand.”
60
S
50
40
30
20
10
D
Q
0
0
5 10 15 20 25 30
Free market versus intervention or central planning
• By virtual definition, the market equilibrium is efficient and no
change by the govt. cannot improve the market allocation
• One expression “not touching the invisible hand” is laissez-faire.
• Central planning cannot improve it because no one person or
agency can effectively absorb and use all the information the market
can process.
•
Example: Russians got in lines for goods not knowing what they
were in line for, thinking if there was a line, it must be worth waiting
for!
23
Summary
• Another principle fleshed out using welfare economics– market
(under certain restrictions) are pretty good at organizing economic
activity (efficiency).
•
Distribution can be another story (equity).
• Modifying these restrictions can invalidate the efficiency outcome.
• Market failures occur:
•
when one buyer has market power (monopoly)
•
transactions have side effects-externalities (pollution)
• Buzzwords – invisible hand/laissez faire
24
SUMMARY
• The height of the D curve reflects the value of the good to buyers—
•
•
•
•
•
their willingness to pay for it.
Consumer surplus is the difference between what buyers are willing
to pay for a good and what they actually pay.
On the graph, consumer surplus is the area between P and the D
curve.
The height of the S curve is sellers’ cost of producing the good.
Sellers are willing to sell if the price they get is at least as high as
their cost.
Producer surplus is the difference between what sellers receive for a
good and their cost of producing it.
On the graph, producer surplus is the area between P and the S
curve.
SUMMARY
• To measure society’s well-being, we use
total surplus, the sum of consumer and producer surplus.
• Efficiency means that total surplus is maximized, that the goods are
produced by sellers with lowest cost, and that they are consumed by
buyers who most value them.
• Under perfect competition, the market outcome is efficient. Altering
it would reduce total surplus.