Consumer, Producer and Markets
 Overall:
Greatest human satisfaction from
scarce resources.
 Allocative Efficiency – resources are
dedicated to the combination of goods
and services that best satisfy consumer
wants
 Production Efficiency – goods and services
are produced using the least cost
combination of resources and technology
 Dynamic Efficiency – how the economy
over time promotes allocative and
productive efficiency
 Positive
– an objective analysis of how
economic variables are related
 Normative – a prescriptive analysis to help
determine what ought to be.
 Welfare economics – the study of how the
allocation of resources affects economic
well-being.
 Economic
agents, unlike many variables in
other sciences, are not passive.
Therefore, it is difficult to measure
willingness to pay.
 Normal Auction – Ascending price with
sale to the highest bidder. May yield the
person who most highly values the item,
but does not measure their maximum
willingness to pay.
 Dutch Auction – Descending Price with
sale to first bidder. May yield the person
who most highly values the good and the
maximum willingness to pay.
So far, we have demonstrated that people
maximize total net benefits from an activity at
the point where MB=MC
 Marginal benefits are equal to the (max.)
willingness to pay and decline as quantity
demanded increase because of the law of
diminishing marginal utility (jelly bean
example).
 Since consumer as price takers in competitive
markets, the price equals the marginal costs to
consumers.
 Consumer surplus equals willingness to pay minus
the price, which is the same as net benefits we
have discussed before.

 Using
the demand curve to measure consumer
surplus
 Before: giving a price and finding the
corresponding quantity demanded
 Now: giving the quantity and finding the amount
people are willing to pay for a good or go
without it
 MB=MC occurs where price intersects the
demand curve and total net benefits=consumer
surplus is maximized.
Cool, no!
The demand curve is usually ready as – at a given
price how much will a consumer buy.
 The maximum willingness to pay is just the buyer
value in Aplia and our measure of the MB.
 Consumer surplus is the difference between
what the consumer is willing to pay and the
price(s) that they have to pay.
 Note that, if the demand curve is the marginal
benefit curve and the price is the marginal cost,
consumer equilibrium is nothing more that
MB=MC and we are back to the stack of boxes
example.

The supply curve is usually ready as – at a given
price how much will a firms sell.
 The minimum willingness to sell is just the seller
cost in Aplia and our measure of the MC.
 Producer surplus is the difference between the
price(s) sellers receive and minimum willingness
to sell or MC.
 Note that, if the supply curve is the marginal
cost curve and the price is the marginal benefit,
the seller equilibrium is nothing more that
MB=MC and we are back to the stack of boxes
example.

(a) Price = $80
Price of
Album
$100
John’s consumer surplus ($20)
80
70
50
Demand
0
1
2
3
4
Quantity of
Albums
Copyright©2003 Southwestern/Thomson Learning
(b) Price = $70
Price of
Album
$100
John’s consumer surplus ($30)
80
Paul’s consumer
surplus ($10)
70
50
Total
consumer
surplus ($40)
Demand
0
1
2
3
4 Quantity of
Albums
Copyright©2003 Southwestern/Thomson Learning
(a) Consumer Surplus at Price P
Price
A
Consumer
surplus
P1
B
C
Demand
0
Q1
Quantity
Copyright©2003 Southwestern/Thomson Learning
(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
Copyright©2003 Southwestern/Thomson Learning
 Consumer
surplus measures the difference
between the (max.) willingness to pay and
the price.
 Producer surplus measure the difference
between the (min.) needed to be willing to
sell and the price.
 Remember,
the Law of Diminishing
Marginal Returns causes marginal costs to
rise in the short-run as output increases.


As more the the variable input is added to the
fixed input, its marginal product eventually
begins to diminish (production exercise in
class).
If all workers are paid the same wage, the
LDMR implies that the extra (marginal) costs of
producing extra (marginal) outputs increases.
 If
the seller is a price taker, they receive the
same price for very output sold. So the
difference between the price and the
marginal cost (the willingness to sell) is the:
Producer
Surplus
(a) Price = $600
Price of
House
Painting
Supply
$900
800
600
500
Grandma’s producer
surplus ($100)
0
1
2
3
4
Quantity of
Houses Painted
Copyright©2003 Southwestern/Thomson Learning
(b) Price = $800
Price of
House
Painting
$900
Supply
Total
producer
surplus ($500)
800
600
Georgia’s producer
surplus ($200)
500
Grandma’s producer
surplus ($300)
0
1
2
3
4
Quantity of
Houses Painted
Copyright©2003 Southwestern/Thomson Learning
(a) Producer Surplus at Price P
Price
Supply
P1
B
Producer
surplus
C
A
0
Q1
Quantity
Copyright©2003 Southwestern/Thomson Learning
(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
Copyright©2003 Southwestern/Thomson Learning
 Assume
competitive markets (many buyers
and sellers, identical products, free entry
and exit, price takers, etc.)
 Assume that consumer surplus measures
consumers economic well-being and producer
surplus that of sellers.
 So, MB = willingness to pay by consumers and
MC = willingness to sell to producers
MB=MC
Occurs where the demand and supply curve
intersect, and
Total Well-being is
Maximized
Price A
D
Supply
Consumer
surplus
Equilibrium
price
E
Producer
surplus
B
Demand
C
0
Equilibrium
quantity
Quantity
Copyright©2003 Southwestern/Thomson Learning
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.
Demand
Quantity
Value to buyers is less
than cost to sellers.
Copyright©2003 Southwestern/Thomson Learning
 Competitive
markets result in the
combination of goods and services that
maximize consumer well-being (allocative
efficiency) and produce goods at least
possible cost (production efficiency).
 Over time, competitive forces will move to
promote allocative and production efficiency
(dynamic efficiency).
Adam Smith, building on the work of other
philosophers, was the first to develop a
comprehensive argument for the efficiency of
markets.
 The efficiency of markets has proven a powerful
force in altering historical perspectives on
effective ways humans can interact.
 The revolutionary idea that the pursuit of selfinterest, tempered by competition, promotes
social interest is the basis for the tremendous
economic growth of the last century.

 If
markets are not competitive, efficiency
might not be guaranteed.
 In some cases, consumer surplus might
not be considered a good measure of
consumer well-being (drugs or
externalities), or producer surplus might
not be a good measure of producer wellbeing (externalities or inefficiency due to
monopoly).
Changes in the allocation of resources alters the
human satisfaction generated from resources.
How do we “maximize” human satisfaction with
as few value judgments as possible? This is
Welfare Economics and Vilfredo Pareto was a
pioneer in the area.
 Pareto Efficient Change – at least one person is
made better off without making someone worse
off.
 Pareto Efficiency – no one can be made better
off without making someone worse off.
 Voluntary trades are Pareto Efficient Changes.

 At
the competitive market equilibrium (in
the absence of market failures such as
monopoly, externalities, and public goods),





MB=MC
Total Surplus (CS+PS) is maximized
All voluntary trades are carried out
All Pareto Efficient Changes are made
Pareto Efficiency holds!
 The
formula for Pareto Efficiency is:
 (MB=)
P=MC
A



market for transplantable organs
Current price is zero and there is a shortage of
transplantable organs
Allowing companies to contract with individuals
to donate organs for a price would likely increase
the supply of organs
Positive versus normative considerations
 Pilgrims,
communal agriculture, and
starvation
 Is
a tuition cap a price control?
NPR presentation
http://www.npr.org/features/feature.php?wfId
=1474621
 Who pays the cost of a college education?
 Why are the costs of a college education rising?





Demand side
Supply side
What are the likely effects of tuition caps?
Increased financial aid as an alternative to
price controls.
 Taxes
create a wedge between the price
buyers pay and sellers receive and result
in a reduction in quantity bought and
sold.
 The reduction in quantity leaves
production at a point where MB>MC and
consumer surplus and producer surplus is
not maximized.
 The consumer and producer surplus that
is lost from not producing where MB=MC is
call the Deadweight Welfare Loss (DWL).
 DWL is the economic cost of taxation.
Price
Supply
Price buyers
pay
Size of tax
Price
without tax
Price sellers
receive
Demand
0
Quantity
with tax
Quantity
without tax
Quantity
Copyright © 2004 South-Western
Price
Supply
Price buyers
pay
Size of tax (T)
Tax
revenue
(T × Q)
Price sellers
receive
Demand
Quantity
sold (Q)
0
Quantity
with tax
Quantity
without tax
Quantity
Copyright © 2004 South-Western
Price
Price
buyers = PB
pay
Supply
A
B
C
Price
without tax = P1
Price
sellers = PS
receive
E
D
F
Demand
0
Q2
Q1
Quantity
Copyright © 2004 South-Western
 The
loss in economic welfare from
restricting voluntary exchange.
 When the MB, or the willingness to pay, is
greater than the MC, or the willingness to
sell, then more voluntary transactions
would increase economic welfare (net
benefits)
 Graph – ignore the tax and just think
about anything that restricts trade like a
price floor or ceiling
 As
in the case of tax incidence, the key to
understanding the extent of DWL are the
elasticities of demand and supply.
 When demand and supply are more elastic or
responsive, the greater will be the decline in
equilibrium quantity for any tax increase.
 The greater the tax, the larger the
deadweight welfare loss.
(a) Inelastic Supply
Price
Supply
When supply is
relatively inelastic,
the deadweight loss
of a tax is small.
Size of tax
Demand
0
Quantity
Copyright © 2004 South-Western
(b) Elastic Supply
Price
When supply is relatively
elastic, the deadweight
loss of a tax is large.
Size
of
tax
Supply
Demand
0
Quantity
Copyright © 2004 South-Western
(c) Inelastic Demand
Price
Supply
Size of tax
When demand is
relatively inelastic,
the deadweight loss
of a tax is small.
Demand
0
Quantity
Copyright © 2004 South-Western
(d) Elastic Demand
Price
Supply
Size
of
tax
Demand
When demand is relatively
elastic, the deadweight
loss of a tax is large.
0
Quantity
Copyright © 2004 South-Western
(a) Small Tax
Price
Deadweight
loss Supply
PB
Tax revenue
PS
Demand
0
Q2
Q1 Quantity
Copyright © 2004 South-Western
(c) Large Tax
Price
PB
Tax revenue
Deadweight
loss
Supply
Demand
PS
0
Q2
Q1 Quantity
Copyright © 2004 South-Western
 Taxes
on labor (federal income tax, social
security, medicare) add up to about a 50%
marginal tax on labor for many US
workers.
 DWL and the labor market



Elastic or inelastic labor supply?
Full time work regardless of wage or is labor
responsive to wages?
Overtime, second earners, retirement,
underground economy (barter and illegal
activity)




Increasing taxes may raise or lower tax revenues. This
occurs for reasons analogous to why increases in prices
may raise or lower total revenue.
Increases in excise taxes raise the price ot the buyer and
lower the price to the seller. This creates disincentives to
buy and to sell.
If tax rates increase (helps tax rev), ceteris paribus, tax
revenue would rise, BUT all is not equal – the quantity
transacted falls (hurts tax rev). Whether taxes revenues
rise or fall depends on the tax elasticity = % change in
Quantity Traded (OE(ffect))/ % change in taxes (TE(ffect)).
If the TE > OE (Et<1)and tax rates increase, tax revenue
will rise. If TE <OE (Et>1), tax revenues will rise.
This is the logic behind the Laffer curve and supply side
economics – large tax rates create a disincentive to work
and invest.
 The


Promoting equity while minimizing tax shifting
and DWL
Is land in inelastic or elastic supply?


land tax and Henry George
Raw land versus improvements
A tax for today?