3
SUPPLY AND DEMAND II: MARKETS AND WELFARE
7
Consumers, Producers, and the
Efficiency of Markets
Revisiting The Market Equilibrium
• The theory of supply and demand shows how
markets allocate scarce resources among
competing needs.
• But are the equilibrium price and quantity the
right price and the right quantity from society’s
point of view?
• Do they maximize the total welfare of buyers and
sellers?
• Whether the market allocation is desirable or not
is the topic of welfare economics.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
3
Welfare Economics
• Welfare economics is the study of how the
allocation of resources affects economic
well-being
• It shows that:
– Both buyers and sellers receive benefits from
taking part in the market
– The equilibrium outcome—that we saw in
Chapter 4—maximizes the total welfare of
buyers and sellers
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
4
Welfare Economics: two main
concepts
• Consumer surplus measures economic
welfare of the buyer.
• Producer surplus measures economic
welfare of the seller.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
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Willingness to pay
• To define consumer surplus we first need
to define “willingness to pay.”
• Willingness to pay is the maximum amount
that a buyer will pay for a good.
• It measures how much the buyer values the
good.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
6
Willingness to pay
• Assume there is a commodity such that every
additional unit of it increases a consumer’s
happiness by the same amount
– In other words, the consumption of additional
units of this commodity induces neither boredom
nor addiction
– Possible examples: potato chips? candy?
• Then the consumer’s willingness to pay for a
product is an accurate measure of the
happiness that he or she gets from it
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
7
Willingness to pay
• continuation from previous slide
• If a bag of potato chips provides an unchanging
amount of happiness, and
• if your willingness to pay is
– 4 bags of potato chips for a shirt and
– 2 bags for a cup of coffee, then
– one can safely say that the shirt makes you twice as happy
as the cup of coffee
– In other words, your willingness to pay for a commodity is
an accurate measure of how much you like that thing
• For a given dollar price of a bag of potato chips, your
willingness to pay can also be expressed in dollars
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
8
Willingness to pay
• continuation from previous slide
• For example,
– if you are willing to pay $15 for a particular shirt, and
– if a bag of potato chips always gives you 3 “haps” of
happiness, and sells at the price of $0.50 each, then
– the shirt gives you 90 “haps” of happiness.
• In other words, your willingness to pay for the shirt
is
– a monetary measure of the happiness you get from
the shirt, which is
– proportional to the happiness you get from the shirt,
as measured in “haps”
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
9
Table 1 Four Possible Buyers’ Willingness to Pay
For a mint-condition
recording of Elvis
Presley’s first album
Consumer Surplus
• Consumer surplus is the buyer’s willingness to
pay for a good minus the amount the buyer
actually pays for it.
– Example: If the Elvis album’s price is $75…
Buyer
Willingness Consumer Buy?
to Pay
Surplus
John
100
Paul
80
George 70
Ringo 50
25
Yes
5
-5
-25
Yes
No
No
11
Market Demand
• The market demand schedule/curve shows
the various quantities that buyers would be
willing and able to purchase at different prices.
– Chapter 4
• We can use the willingness-to-pay numbers to
calculate the quantities demanded at every
price
– That is, we can calculate the market demand
schedule/curve from the willingness-to-pay
numbers
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
12
The Demand Schedule
Buyer
Willingness
to Pay
John
100
Paul
80
George 70
Ringo
50
13
Figure 1 The Demand Curve
Price of
Album
Buyer
Willingness to Pay
John
100
Paul
80
George 70
John’s willingness to pay
$100
Ringo
Paul’s willingness to pay
80
George’s willingness to pay
70
Ringo’s willingness to pay
50
Demand
0
50
1
2
3
4
The height of the
demand curve at any
quantity shows the
willingness to pay of
whoever bought the
last unit.
Quantity of
Albums
Copyright©2003 Southwestern/Thomson Learning
Area of a Rectangle
Area = Width × Height
Height
Width
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
15
Figure 2 Measuring Consumer Surplus with the
Demand Curve
Buyer
Willingness Consumer
(a) Price = $80.01
Price of
Album
Buy?
to Pay
Surplus
John
100
20
Yes
Paul
80
0
No
George
70
-10
No
Ringo
50
-30
No
$100
1. The area under the demand
curve measures the total
willingness to pay for the
quantity demanded.
80
70
2. It is also the maximum
willingness to pay that could
be generated from that
quantity.
50
Demand
0
John’s willingness to pay ($100)
1
2
3
4
Quantity of
Albums
The market and the planner
• Suppose the government has one
copy of the Elvis album. The
government’s goal is to give it to
one of the four guys so as to
generate the maximum happiness.
• Who will get the government’s
copy?
• Obviously, John.
• Lesson: The market does the
best that the government could
have done
Price = $80
Buyer
Willingness
to Pay
John
100
Paul
80
George
70
Ringo
50
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
17
Figure 2 Measuring Consumer Surplus with the
Demand Curve
Buyer
Willingness Consumer
(b) Price = $70.01
Price of
Album
$100
to Pay
Surplus
John
100
30
Yes
Paul
80
10
Yes
George
70
0
No
Ringo
50
-20
No
1. The area under the demand
curve measures the total
willingness to pay for the
quantity demanded.
80
70
50
2. It is also the maximum
willingness to pay that could
be generated from that
quantity.
Demand
0
John’s willingness to pay
Buy?
1
4 Quantity of
Albums
Paul’s willingness to pay
2
3
Interpersonal comparability
• We just saw
– that the total area under the demand curve is $180, and
– that is also the total willingness to pay of John and Paul
• But can we say it is the total happiness of John and Paul?
• Yes,
– if there is a commodity—say, a bag of potato chips—that
provides an unchanging amount of happiness to the consumer,
and
– if John’s happiness and Paul’s happiness are comparable, and
– if both John and Paul get the same happiness from a bag of
potato chips
• That’s a lot of if’s!
• But we will make these simplifying assumption anyway
– Not just for John and Paul, but for everybody
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
19
Utilitarianism
• The idea that
– the happiness of an individual can be measured
numerically,
– the happiness of a group of people can be measured
numerically,
– the happiness of a group of people is simply the sum
of the numbers representing the happiness of the
individual members of the group, and that
– social policy should seek to maximize the total
happiness of society,
– is called utilitarianism
• The welfare analysis in this chapter takes
utilitarianism as its guiding philosophy
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
20
The market and the planner
• Suppose the government has two
copies of the Elvis album. The
government’s goal is to give them
to two of the four guys so as to
generate the maximum happiness.
• Who will get the government’s
copies?
• Obviously, John and Paul.
• The market does the best that
the government could have done
Price = $70
Buyer
Willingness
to Pay
John
100
Paul
80
George
70
Ringo
50
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
21
Willingness to Pay from the Demand Curve
(a) Willingness to Pay at Price P
Price
A
The area under the demand
curve also measures the
maximum willingness to pay
that could be obtained from
Q1 units
P1
B
C
Demand
0
Q1
Quantity
Using the demand curve to measure
willingness to pay
• In general, the area under the demand
curve up to the quantity demanded is a
graphical measure of the total willingness
to pay of the buyers.
• It is also the maximum willingness to pay
that can be obtained from that quantity
– That is, the government could not give away
that quantity in a way that generates higher
willingness to pay.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
23
Figure 3 How the Price Affects Consumer
Surplus
(a) Consumer Surplus at Price P
Price
A
Consumer Surplus (ABC) +
Total Payment (OBCQ1) =
Willingness to Pay (OACQ1)
Consumer
surplus
P1
B
C
Total
Payment
0
Demand
Q1
Quantity
Using the Demand Curve to Measure
Consumer Surplus
• In general, the area below the demand
curve and above the price measures the
consumer surplus.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
28
Figure 3 How the Price Affects Consumer
Surplus
(b) Consumer Surplus at Price P
Price
A
Initial
consumer
surplus
P1
P2
0
C
B
Consumer surplus
to new consumers
F
D
E
Additional consumer
surplus to initial
consumers
Q1
Demand
Q2
Quantity
Shifts in Demand
• We have seen that the demand curve can
shift, for reasons such as
– a change in tastes, and
– a change in the prices of related goods
• See chapter 4
• Given that the demand for a product can shift
as a result of a change in the price of a
related good, does it make sense to say that
the area under the demand curve measures
the happiness consumers get from the
product?
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
30
Shifts in Demand
• Continued from the previous slide
• Yes!
– Keep in mind that the area under the demand curve is a monetary
measure of the happiness obtained by buyers
– The objective or psychological happiness obtained from a shirt may be
unchanged even if the monetary willingness to pay for the shirt
changes, perhaps because of a change in the price of a related good
• In an earlier slide, a bag of potato chips was assumed to always
provide 3 “haps” of happiness, and sold at a price of $0.50.
Consequently, consumers were wiling to pay $15 for a shirt that
provided 90 “haps” of happiness.
• It follows that if the price of a bag of potato chips rises to $1,
consumers would then be willing to pay $30 for the same shirt,
leading to an upward shift in the demand curve for shirts.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
31
Producer Surplus
• Producer surplus is the amount a seller is
paid for a good minus the seller’s cost.
• It measures the net benefit to sellers
• It is almost but not quite the same as profit.
– We’ll discuss this later
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
33
Cost of production
• The cost of production is the market value
of all resources used in production
– By all, I do mean all. Even if some resources
used in production were obtained for free,
their market value must be included in cost.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
34
Table 2 The Cost of Painting a House for
Four Possible Sellers
The Supply Schedule and the
Supply Curve
Seller
Cost ($)
Mary
900
Frida
800
Georgia
600
Grandma 500
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
36
Figure 4 The Supply Schedule and the Supply
Curve
The height of the supply curve
at any quantity shows the
production cost to whoever
produces the last unit.
Seller
Cost ($)
Mary
900
Frida
800
Georgia
600
Grandma 500
Producer Surplus
• Producer surplus is the amount a seller is paid
minus the seller’s cost
– Example: If the going price for getting a house painted
is $700 we get the following table.
Seller
Cost ($) Producer
Surplus
Sell?
Mary
900
-200
No
Frida
800
-100
No
100
200
Yes
Yes
Georgia 600
Grandma 500
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
38
Using the Supply Curve to Measure
Producer Surplus
• The area below the price and above the
supply curve measures the producer
surplus.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
39
Figure 5 Measuring Producer Surplus with the
Supply Curve
(a) Price = $599.99
Price of
House
Painting
1. The area under
the supply curve is
the cost of the
quantity supplied
Supply
2. It is also the
lowest cost for that
quantity
$900
800
600
500
Grandma’s Cost
($500)
Seller
Cost ($) Producer
Surplus
Sell?
Mary
900
-300
No
Frida
800
-200
No
Georgia
600
0
No
100
Yes
Grandma 500
0
1
2
3
4
Quantity of
Houses Painted
Is there a better alternative to the
market system?
• If the government had to get one
house painted, who would get the
job?
• Grandma, of course, if the
government had any sense.
• And that’s exactly what happens
in the market outcome.
• The market achieves the best
that the government could have
achieved
Seller
Cost ($)
Mary
900
Frida
800
Georgia
600
Grandma 500
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
43
Figure 5 Measuring Producer Surplus with the
Supply Curve
(b) Price = $799.99
Price of
House
Painting
Supply
1. The area under
the supply curve is
the cost of the
quantity supplied
2. It is also the
lowest cost for that
quantity
$900
800
600
500
0
1
Grandma’s cost
Georgia’s cost
2
3
Seller
Cost ($) Producer
Surplus
Sell?
Mary
900
-100
No
Frida
800
0
No
Georgia
600
200
Yes
Grandma 500
300
Yes
4
Quantity of
Houses Painted
Is there a better alternative to the
market system?
• If the government had to get two
houses painted, who would get
the job?
• Grandma and Georgia, of course.
• And that’s exactly what happens
in the market outcome.
• The market achieves the best
that the government could have
achieved
Seller
Cost ($)
Mary
900
Frida
800
Georgia
600
Grandma 500
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
45
Figure 6 How the Price Affects Producer
Surplus
(a) Producer Surplus at Price P
Price
Supply
P1
B
Producer
surplus
A
0
C
Total Revenue (OBCQ1) =
Production Cost (OACQ1) +
Producer Surplus (ABC)
Production
Cost
Q1
Quantity
Figure 6 How the Price Affects Producer
Surplus
(b) Producer Surplus at Price P
Price
Supply
Additional producer
surplus to initial
producers
P2
P1
D
E
F
B
Initial
producer
surplus
C
Producer surplus
to new producers
A
0
Q1
Q2
Quantity
MARKET EFFICIENCY
• Consumer surplus and producer surplus
may be used to address the following
questions:
– Is our free market system a good way of
running our economy?
– Could we design a better system?
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
49
MARKET EFFICIENCY
Consumer Surplus
= Value to buyers – Amount paid by buyers
and
Producer Surplus
= Amount received by sellers – Cost to
sellers
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
50
MARKET EFFICIENCY
Total surplus
= Consumer surplus + Producer surplus
= Value to buyers – Amount paid by buyers
+ Amount received by sellers – Cost to
sellers
= Value to buyers – Cost to sellers
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
51
MARKET EFFICIENCY
• In fact, we can go further and say that
• Total Surplus = maximum willingness to
pay – minimum production cost
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
52
MARKET EFFICIENCY
• An economic outcome is efficient if there is
no feasible way to make the total surplus
any higher.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
53
Figure 7 Consumer and Producer Surplus in
the Market Equilibrium
Price A
D
Supply
Consumer
surplus
Equilibrium
price
E
Producer
surplus
B
Demand
C
0
Equilibrium
quantity
Quantity
Figure 7 Consumer and Producer Surplus in
the Market Equilibrium
Price A
Total Value (or,
willingness to pay)
Total
Surplus
D
Supply
Consumer
surplus
Equilibrium
price
E
Producer
surplus
B
Demand
Cost
C
0
Equilibrium
quantity
Quantity
The best feasible outcome
Price A
Total Value (also,
Maximum Value)
Maximum
Total
Surplus
D
As long as we produce
the equilibrium quantity,
it would be impossible
to increase the Total
Surplus by reallocating
production and
consumption.
Consumer
surplus
Equilibrium
price
E
Producer
surplus
C
0
B
Cost (also,
Minimum
Cost)
Equilibrium
quantity
Supply
Demand
But is the
equilibrium
output the right
output to
produce?
Quantity
The best feasible outcome
Price A
Minimum
WTP lost
Equilibrium
price
D
Society would be
worse off if it produces
less than the
equilibrium quantity
E
Maximum
Cost saved
Supply
B
Demand
C
0
Alternative
Equilibrium
quantity
Quantity
The best feasible outcome
Price A
D
Equilibrium
price
C
0
Society would be
worse off if it produces
more than the
equilibrium quantity
E
Maximum
Value of
extra
output
Minimum
Cost
Equilibrium
quantity
Supply
B
Demand
Alternative
Quantity
MARKET EFFICIENCY
• Three Insights Concerning Market
Outcomes
– Free markets allocate the goods produced to
the buyers who value them most highly, as
measured by their willingness to pay.
– Free markets allocate production of goods to
those who can produce them at least cost.
– Free markets produce the quantity of goods
that maximizes the sum of consumer and
producer surplus.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
59
Figure 8 The Efficiency of the Equilibrium
Quantity
Price
Supply
Value
to
buyers
Cost
to
sellers
Cost
to
sellers
0
Value
to
buyers
Equilibrium
quantity
Value to buyers is greater
than cost to sellers.
Value to buyers is less
than cost to sellers.
Demand
Quantity
The Invisible Hand
• We pursue our self-interest, not the social
interest
• It is, therefore, natural to think that the free
market would lead to chaos
• And yet, as we just saw, the free market
outcome is unimprovable
• This idea was most famously proposed by
Adam Smith (1723 – 1790), the father of
modern economics.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
62
The Invisible Hand
• ...[E]very individual … neither intends to promote the
public interest, nor knows how much he is promoting it.
… [H]e intends only his own security; and by directing
that industry in such a manner as its produce may be of
the greatest value, he intends only his own gain, and he
is in this, as in many other cases, led by an invisible
hand to promote an end which was no part of his
intention. Nor is it always the worse for the society that it
was no part of it. By pursuing his own interest he
frequently promotes that of the society more effectually
than when he really intends to promote it. I have never
known much good done by those who affected to trade
for the public good.
• The Wealth of Nations, Adam Smith, 1776
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
63
Ticket Scalping
• Ticket scalping is often frowned upon and
sometimes considered illegal
– See http://en.wikipedia.org/wiki/Ticket_resale
• But a typical view among economists is
that “consenting adults should be able to
make economic trades when they think it
is to their mutual advantage”
• Scalping increases the economy’s
efficiency
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
64
Market for organs
• Should people be allowed to sell, say, their
kidneys?
• The efficiency of the economy will increase.
• What about fairness?
– Rich will buy the kidneys; the poor will not. But
– Right now healthy people have extra kidneys
while the sick have none.
– The sale of organs may be more acceptable if
organ purchases by the poor were paid for with
taxpayers’ money so that rich and poor had equal
access
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
65
WHEN MARKETS FAIL
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
66
However, markets can go wrong
• Market Power
• Externalities
• Fairness
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
67
MONOPOLY
• If a market system is not perfectly
competitive, firms may have market power.
– Market power is the ability to influence prices.
– Market power can cause markets to be
inefficient because it keeps price and quantity
from the equilibrium of supply and demand.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
68
EXTERNALITIES
• Externalities
– are created when a market outcome affects
individuals other than buyers and sellers in that
market.
– cause welfare in a market to depend on more
than just the value to the buyers and cost to
the sellers.
• When buyers and sellers do not take externalities
into account when deciding how much to
consume and produce, the equilibrium in the
market can be inefficient.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
69
FAIRNESS
• In addition to market efficiency, a social
planner might also care about equity – the
fairness of the distribution of well-being
among the various buyers and sellers.
• The free market economic system is
efficient but not necessarily fair
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
70
Health Care: a big exception
• In most advanced countries, government policies
regarding health care routinely disregard the idea that
free markets are best
• In the United Kingdom, the government builds
hospitals, hires doctors and nurses, buys
pharmaceutical drugs, and provides medical care to all
residents
• Patients get no bills; tax revenues are used to pay all
costs
• Fees of private doctors are paid by the government
• Performance indicators are high
• Costs are low
• There is virtually no clamor for privatization
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
71
Video: Scroogenomics
• Heard the one about the economist who
gave cash as a Valentines Day gift?
– Scrooge alert: Your holiday spending may
result in an economic loss by Paul Solman,
PBS Newshour, December 23, 2013.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
72
Summary
• Consumer surplus equals buyers’
willingness to pay for a good minus the
amount they actually pay for it.
• Consumer surplus measures the benefit
buyers get from participating in a market.
• Consumer surplus can be computed by
finding the area below the demand curve
and above the price.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
73
Summary
• Producer surplus equals the amount sellers
receive for their goods minus their costs of
production.
• Producer surplus measures the benefit
sellers get from participating in a market.
• Producer surplus can be computed by
finding the area below the price and above
the supply curve.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
74
Summary
• An allocation of resources that maximizes
the sum of consumer and producer surplus
is said to be efficient.
• Policymakers are often concerned with the
efficiency, as well as the equity, of
economic outcomes.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
75
Summary
• The equilibrium of demand and supply
maximizes the sum of consumer and
producer surplus.
• This is as if the invisible hand of the
marketplace leads buyers and sellers to
allocate resources efficiently.
• Markets do not allocate resources
efficiently in the presence of market
failures.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
76