Consumers, Producers and the Efficiency of Markets

1
Chapter 7

• Consumers, Producers and the Efficiency of Markets

2
Objectives

• 1. Understanding how consumers willingness and
  ability to pay fora good determines the demand
  curve.
• 2. Learn the concept of consumer surplus and how
  to measure it.
• 3. Understand how sellers cost of production
  determine the supply curve.

3
Objectives

• 4. Learn the concept of producer surplus and how
  to measure it, and ...
• 5. ... recognize that market equilibrium
  maximizes total surplus in a market.

4
Market Equilibrium Revisited Does the
equilibrium price and quantity result in the
maximum total welfare of buyer and seller?
5
Market Equilibrium RevisitedDoes the equilibrium
price and quantity result in the maximum total
welfare of buyer and seller?

• Market equilibrium illustrates the way markets
  allocate scarce resources.
• But does it answer whether that market
  allocation is desirable?
• Turn to Welfare Economics to answer the question.

6
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.
• The equilibrium in a market makes the sum of
  these benefits as large as possible.

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Welfare Economics

• Equilibrium in the market results in maximum
  benefits, and thereforetotal welfare for both
  the buyer andthe seller.
• Welfare Economics from theBuyer Side and the
  Seller Side
• Consumer Surplus
• Producer Surplus

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Welfare Economics Consumer Surplus

• Market Demand Curve depicts the various
  quantities that buyers would want to purchase at
  different prices.
• What determines how much a consumer would be
  willing to pay (the maximum price) for a good or
  service?
• Answer The expected benefits received or
  Utility.

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Utility is...

• the satisfaction (benefit) that a consumer
  expects to receive from consuming a good or
  service.
• the power to satisfy a want.

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Marginal Utility (MU) is...

• the amount of utility (satisfaction) that one
  more or one less unit of consumption adds to or
  subtracts from total utility.
• Consumers try to obtain the largest possible
  total satisfaction (utility) from the mix of
  goods and services they buy with their incomes.

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Consumer Surplus is...

• the maximum amount a consumer will be willing
  to pay for a good depends upon the expected
  utility (benefits) of that good.
• Willingness to Pay
• The maximum price that a buyer is willing and
  able to pay for a good.
• Measures how much the buyer values the good or
  service.

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Measuring Consumer Surplus with the Demand Curve
Price of Album
100
Johns consumer surplus (10)
80
Pauls consumer surplus (10)
70
Total consumer surplus (40)
50
Demand
13
Four Possible Buyers Willingness to Pay...
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Consumer Surplus Verbal Definition

• The amount a buyer is willing to pay for a good
  minus the amount the buyer actually pays for it.

D
15
How the Price Affects Consumer SurplusFigure 7-3
(a) -- Consumer Surplus at Price P1
Price
A
Consumer Surplus
P1
B
C
Demand
Quantity
0
Q1
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How the Price Affects Consumer SurplusFigure 7-3
(b) -- Consumer Surplus at Price P2
Price
A
Initial Consumer Surplus
Additional consumer surplus to initial consumers
C
P1
B
Consumer Surplus to New Consumers
F
P2
D
E
Demand
Quantity
0
Q1
Q2
17
Consumer Surplus Graphical
S
Pmax
Consumer Surplus
PE
D
QE
18
Consumer Surplus and Market Price

• The area below the demand curve and above the
  market price measures the consumer surplus in a
  market. Hence,
• A lower market price will increase consumer
  surplus
• A higher market price will reduce consumer surplus

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Consumer Surplus and Economic Well-Being

• Consumer surplus, the amount that buyers are
  willing to pay for a good minus the amount they
  actually pay for it, measures the benefit that
  buyers receive from a good as the buyers
  themselves perceive it.

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Consumer Surplus Mathematically

• Maximum Price 11
• Market Price 6
• Quantity Purchased 6
• Assume Price drops 1 for every additional unit
  sold.
• Consumer Surplus 15
• 51 - 36 15
• (11109876) - (6 x 6) 15

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11
10
9
8
7
6
Market Price
D
6
5
4
3
2
1
Quantity Purchased
22
11
10
Total Consumer Benefits
9
8
7
6
D
6
5
4
3
2
1
23
11
10
9
8
Consumers Expense
7
6
D
6
5
4
3
2
1
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Consumer Benefit -Consumer Expense CONSUMER
SURPLUS!
11
10
9
8
51 - 36 15
7
6
D
6
5
4
3
2
1
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Quick Quiz

• Illustrate, with a demand curve, the consumer
  surplus for turkey.
• Explain in words what consumer surplus measures.
• Discuss changes in consumer surplus as price
  changes.

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Producer Surplus

• Market Supply Revisited
• Depicts the various quantities that suppliers
  would be willing to sell at different prices.
• May be viewed as a measure of supplier costs,
  i.e.. the opportunity cost to the seller of
  supplying various quantities of the good.

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Producer Surplus

• Market Supply The marginal opportunity cost of
  production increases as market output expands.
• Because the producers cost is the lowest price
  he/she would accept it may be considered a
  measure of his/her willingness to sell.

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Measuring Consumer Surplus with the Supply Curve
Figure 7-5a
Price of House Painting
Supply
Total producer surplus (500)
900
800
Georgias producer surplus (200)
600
500
Grandmas producer surplus
0
Quantity of Houses Painted
1
2
3
4
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The Costs of Four Possible Sellers...
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Producer Surplus Verbal Definition
S

• The amount a seller is paid minus the cost of
  production.
• Producer surplus measures the benefit to sellers
  of participating in a market.

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How the Price Affects Producer SurplusFigure 7-6
(a) -- Producer Surplus at Price P1
Price
Supply
B
P1
C
A
Producer Surplus
Q1
0
Quantity
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How the Price Affects Producer SurplusFigure 7-6
(b) -- Producer Surplus at Price P2
Additional producer surplus to initial producers
Price
Supply
D
E
P2
F
B
Producer surplus to new producers
P1
C
A
Producer Surplus
Q1
0
Quantity
Q2
33
Producer Surplus Mathematically

• Minimum Price 1
• Market Price 6
• Quantity Sold 5
• Assume Price increases 1 for every additional
  unit sold.
• Producer Surplus 15
• 30 - 15 15
• (6 x 5) - (1 2 3 4 5) 15

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S
6
5
4
3
2
1
6
5
4
3
2
1
35
Total Producer Benefits
S
6
5
4
3
2
1
6
5
4
3
2
1
36
Producer Surplus
S
6
5
4
Producer Costs
3
2
1
6
5
4
3
2
1
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Market Efficiency

• Under the assumptions of perfect competition and
  no externalities, the economic well-being of a
  society is measured as the sum of consumer
  surplus and producer surplus.
• Market Efficiency is attained whentotal surplus
  is maximized, a point where resource allocation
  is efficient.

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Economic Well-Being and Total Surplus
and
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Economic Well-Being and Total Surplus
or
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Market Efficiency
S
PE
D
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Market Efficiency
S
Consumer Surplus
PE
Producer Surplus
D
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Market Efficiency

• 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.

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Market Efficiency Three observations

• Free markets allocate the supply of goods to the
  buyers who value them most highly.
• Free markets allocate the demand for goods to the
  sellers who can produce them at least cost.
• Free markets produce the quantity of goods that
  maximizes the sum of consumer and producer
  surplus.

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Market Efficiency Invisible Hand

• In a free market system the many buyers and
  sellers are interested in their own well-being,
  self-interest.
• As market participants are motivated by
  self-interest a process of coordination and
  communication takes place so that buyers and
  sellers are directed to the most efficient
  outcome.
• As if by an Invisible Hand, the free market
  system reaches efficiency.

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The Efficiency of the Equalibrium
Price
S
Value to Buyers
Cost to sellers
Cost to sellers
Value to Buyers
D
0
Quantity

• Equilibrium quantity

Value to buyers is greater than cost to sellers.
Value to buyers is less than cost to sellers.
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Quick Quiz

• Draw the supply and demand for turkey.
• In the equilibrium, show the producer and
  consumer surplus.
• Explain why producing more turkey will lower
  total surplus.

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Market Failure

• If a market system is not one of perfect
  competition, control over prices leads to Market
  Power.
• The ability by one buyer or seller to control
  market price.
• Market Power causes markets to be inefficient,
  and thus fail.

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Market Failure

• If a market system affects individuals other than
  buyers and sellers of that market, side-effects
  are created and called Externalities.
• Benefits or costs imposed on a third party who is
  not the consumer or the producer.
• Externalities cause markets to be inefficient,
  and thus fail.

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Externalities

• Externalities are created when a market outcome
  affects individuals other than buyers and sellers
  in that market.
• Externalities 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.

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Summary

• 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.

51
Summary

• 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.

52
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.

53
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.