A rational decision maker makes choices so as best
to achieve a clear goal.
• Rational behavior most often requires marginal
analysis in which the marginal benefit and marginal
cost of a incremental action are compared.
• Economists assume that consumers take actions so as to
maximize their satisfaction or utility.
• An implication of rationality on the part of consumers is
that their demand curves for a good reflect their
marginal benefit from the good.
Willingness to pay is the maximum amount that a
buyer is willing to pay for a good.
movies
per
month
1
2
3
4
5
6
7
marginal
benefit
($/movie)
$14
$12
$10
$8
$6
$4
$2
total
benefit
($)
$14
$26
$36
$44
$50
$54
$56
Marginal willingness to pay (marginal benefit) is the maximum
amount a buyer is willing to pay for an incremental unit.
Total willingness to pay (total benefit) is the maximum amount
a buyer is willing to pay for the total number of units received.
The consumer surplus associated with a particular quantity
is the total one is willing to pay for that quantity of the
good minus what one actually pays.
What if the price of movies tickets is $7.00 each?
movies
per
month
1
2
3
4
5
6
7
marginal
benefit
($/movie)
$14
$12
$10
$8
$6
$4
$2
total
benefit
($)
$14
$26
$36
$44
$50
$54
$56
total cost
(P = $7.00)
$7
$14
$21
$28
$35
$42
$49
consumer
surplus
(P=$7.00)
$7
$12
$15
$16
$15
$12
$7
A consumer seeking to maximize satisfaction will choose the
number of movies that maximizes her net gain or consumer
surplus (for the given price).
movies
per
month
1
2
3
4
5
6
7
marginal
benefit
($/movie)
$14
$12
$10
$8
$6
$4
$2
marginal
cost
($/movie)
$7
$7
$7
$7
$7
$7
$7
consumer
surplus
(P=$4.00)
$7
$12
$15
$16
$15
$12
$7
In maximizing total net benefit (i.e., consumer surplus), the
individual will buy each units having a marginal benefit that
is at least as great as the marginal cost.
$ per
movie
movies
per
month
1
2
3
4
5
6
7
marginal
benefit
($/movie)
$14
$12
$10
$8
$6
$4
$2
marginal
cost
($/movie)
$7
$7
$7
$7
$7
$7
$7
consumer
surplus
(P=$4.00)
$7
$12
$15
$16
$15
$12
$7
14
12
10
8
6
4
2
1 2
3 4 5
6 7 8
movies
$ per
movie
movies
per
month
1
2
3
4
5
6
7
marginal
benefit
($/movie)
$14
$12
$10
$8
$6
$4
$2
marginal
cost
($/movie)
$7
$7
$7
$7
$7
$7
$7
consumer
surplus
(P=$4.00)
$7
$12
$15
$16
$15
$12
$7
14
12 $7
10
$5
$3
8
$1
6
P = $7.00
4
2
1 2
3 4 5
6 7 8
movies
$ per
movie
14
movies
per
month
1
2
3
4
5
6
7
marginal
benefit
($/movie)
$14
$12
$10
$8
$6
$4
$2
marginal
cost
($/movie)
$4
$4
$4
$4
$4
$4
$4
consumer
surplus
(P=$4.00)
$10
$18
$24
$28
$30
$30
$28
12 $7
10
$5
$3
8
$1
6 $3 $3 $3 $3
4
$2
P = $4.00
2
$ per
movie
1 2
3 4 5
6 7 8
movies
14
12
10
$10
$8
8
6
4
$6
$4
$2
P = $4.00
2
1 2
3 4 5
6 7 8
movies
consumer surplus when P = $20
(area abc):
P
40
a
initial surplus
$400
$400  1 (40  20) (40  0)
2
20
consumer surplus when P = $10
(area amr):
c
b
$400
10
m
$900  1 (40  10) (60  0)
n
$100
40
2
increase in surplus due to
price reduction on initial
quantity $400 = (20-10)40
r
60
D
Q
increase in surplus from
purchase of additional
units of Q
Price of
House
Painting
Supply
Mary’s cost
Frida’s cost
$900
800
Georgia’s cost
Grandma’s cost
600
500
0
1
2
3
4
Quantity of
Houses Painted
A supply curve reflects the marginal opportunity co
of sellers making the good available.
Measuring Producer Surplus with the
Supply Curve...
Price of
House
Painting
Price = $800
$900
Supply
Total
producer
surplus ($500)
800
Georgia’s producer
surplus ($200)
600
500
Grandma’s producer
surplus ($300)
0
1
2
3
4
Quantity of
Houses Painted
Price of
House
Painting
Price = $800
Supply
$900
800
600
500
0
1
2
3
4
Quantity of
Houses Painted
Producer surplus is the total amount sellers receive in payment
for a good minus the sellers’ (total) opportunity cost.
The area below the price and above the supply curve measures
the producer surplus in a market.
How Price Affects Producer Surplus...
Price
Supply
Additional producer
surplus to initial
producers
P2 D
P1 B
Initial
Producer
surplus
E
F
C
Producer surplus
to new producers
A
0
Q1
Q2
Quantity
The diamond-water paradox refers to the puzzling observation that
markets place a very high value on diamonds at the same time that
water is cheap.
However, in reality there is no paradox of value.
P
D
S
P1
Q1
Q
•Market prices reflect marginal values and marginal costs.
•When a good is abundant, the marginal value of the last unit can be quite
low even though the total net benefit (i.e., consumer surplus) is quite large.
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.
Consumer surplus measures economic welfare on
the buyer’s side.
Producer surplus measures economic welfare on
the seller’s side.
Total Surplus
consumer surplus = value to buyers - amount paid
producer surplus =
amount paid - costs to sellers
total surplus = consumer surplus + producer surplus
= value to buyers - costs to sellers
Welfare economics is concerned with both
efficiency and equity.
Efficiency is concerned with maximizing the
total surplus received by all members of
society.
Equity is concerned with the fairness of the
distribution of well-being among the
members of society.
For an allocation of resources to be efficient, each of
the following is needed:
• Efficiency in production: Any given level of
output must be produced in the least costly
manner.
• Efficiency in exchange: Any given level of output
must be consumed by those individuals who value
it the most.
• Efficiency in the mix and levels of goods and
services
P
S
P
sa
P0
P0
P
sb
P0
P
P0
sc P
se
P0
D
Q0
Q
q0a
qa
q0b
qb
q0c qc
q0e qe
Free markets result in the total output produced, here Q0, being
produced by the sellers who can produce at the least cost.
In this way, the given level of output is produced in the least
costly manner.
P
P
P
P
P0
P0
P0
P0
dh
q0h
di
qh
q0i
qi
q0j
P
S
P0
dj
dk
qj
q0k qk
D
Q0
Q
Free markets result in the total output produced, here Q0, being
allocated to buyers who value the good most highly.
In this way, for the given level of output the total benefit to
buyers is maximized.
P
consumer surplus
S
P0
producer surplus
D
Q0
Q
Free markets produce the quantity of goods, here Q0, that
maximize the sum of producer and consumer surplus.
a
P
S
c
P0
b
e
f
D
Q0 Q 2 Q
Producing any units of Q greater than Q0, will result in a fall in
total surplus since the marginal cost to sellers exceed the
marginal value to buyers.
a
P
S
m
c
P0
b
n
Q1
D
Q0
Q
Reducing Q to a level below Q0 would result in a reduction in
total surplus since the marginal cost of those units to sellers is
less than the marginal value of those units to buyers.
Even though buyers and sellers are only concerned about their
own (individual) welfare, demand and supply forces in
competitive markets operate like an “invisible hand,” leading to
the total benefit to buyers and sellers being maximized.
Quotes from Adam Smith in The Wealth of Nations
“It is not from the benevolence of the butcher, the brewer, or
the baker that we expect our dinner, but from their regard to
their own interest.”
“Every individual … by pursuing his own interest .. promotes
that of society. He is led … by an invisible hand to promote
an end which was no part of his intention.”
Problems impeding the functioning of markets:
Lack of competition: Competition in markets often is less
than perfect.
Externalities: when the actions of either buyers or sellers
affect third parties, maximizing the total benefits to buyers
and sellers is not not the same as maximizing the total
surplus or net benefit to society.
In general, there is market failure when unregulated markets
fail to allocate resources efficiently.