3

SUPPLY AND DEMAND II: MARKETS AND WELFARE

Consumers,
Producers, and the
Efficiency of Markets

Midterm I
Will cover the material from Chapters 1, 2, 4, 5, 6, 7.
Will consist of 50-60 multiple-choice and true-false
questions
Closed-everything (i.e., books, notes, laptops and etc.)
Bring only calculators

Try to finish Homework Assignment 3 before the date

of the Midterm (Sept. 12th) even though it will be
available through September 15th.
It may take me up to 7 work days to grade the
midterm.

REVISITING THE MARKET

EQUILIBRIUM
Do the equilibrium price and quantity maximize the
total welfare of buyers and sellers?
Market equilibrium reflects the way markets
allocate scarce resources.
Whether the market allocation is desirable can be
addressed by welfare economics.

Welfare Economics
Welfare economics is the study of how the allocation

of resources affects economic well-being.

Note: we are using the word welfare in the sense of wellbeing and not public assistance.

Buyers and sellers receive benefits from taking part

in the market.
We will show:
Equilibrium in the market results in maximum benefits,
and therefore maximum total welfare for both the
consumers and the producers of the product.

Welfare Economics
Consumer surplus measures economic welfare
from the buyers side.
Producer surplus measures economic welfare
from the sellers side.

CONSUMER SURPLUS
Willingness to pay is the maximum amount
that a buyer will pay for a good.
It measures how much the buyer values a given
quantity of the good or service.

Consumer surplus is the buyers willingness

to pay for a good minus the amount the buyer
actually pays for it.

Table 1 Four Possible Buyers Willingness to Pay

A rare vinyl record of Elvis Presleys first album is being
auctioned off
Four bidders: John, Paul, George and Ringo
The bidding starts at $10 and the price goes up until..
John wins the auction
by bidding just above
$80.
Johns consumer surplus is
the difference between what
he is willing to pay and what
he actually pays:
$100-$80=$20.
What if there are two records on sale and both have to be sold
at the same price? (And no buyer wants to have two records.)
Copyright2004 South-Western

Time Machine is on the Auction Block

A new technology has been developed that allows individuals to travel
backward or forward in time. We want to identify the value this time
machine provides to consumers.
Lets assume the four consumers who most desire this product are in
this class.
is the consumer who most values this product. He wants to go back to the
time of the dinosaurs. He is willing to pay $3000.

10

Time Machine is on the Auction Block

A new technology has been developed that allows individuals to travel
backward or forward in time. We want to identify the value this time
machine provides to consumers.
Lets assume the four consumers who most desire this product are in
this class.
is the consumer who most values this product. He wants to go back to the
time of the dinosaurs. He is willing to pay $3000.
is the consumer with the next highest willingness to pay. She would like to
see 200 years in the future. Shed pay $2500.

11

Time Machine is on the Auction Block

A new technology has been developed that allows individuals to travel
backward or forward in time. We want to identify the value this time
machine provides to consumers.
Lets assume the four consumers who most desire this product are in
this class.
is the consumer who most values this product. He wants to go back to the
time of the dinosaurs. He is willing to pay $3000.
is the consumer with the next highest willingness to pay. She would like to
see 200 years in the future. Shed pay $2500.
is the next highest bidder. Hed like to relive this entire semester. Hell pay
up to $800.

12

Time Machine is on the Auction Block

A new technology has been developed that allows individuals to
travel backward or forward in time. We want to identify the value
this time machine provides to consumers.
Lets assume the four consumers who most desire this product are in
this class.
is the consumer who most values this product. He wants to go back to the
time of the dinosaurs. He is willing to pay $3000.

is the consumer with the next highest willingness to pay. She would like to
see 200 years in the future. Shed pay $2500.
is the next highest bidder. Hed like to relive this entire semester. Hell pay
up to $800.
is our fourth consumer. Shed pay $200 to move the clock forward to the
end of this class period.
A
$3,000
B

$2,500

$800

$200

13

Time Machine is on the Auction Block

What if the price for a ride in time is $500?

CS

$3,000

$2,500

$800

$200

Total

14

Time Machine is on the Auction Block

What if the price for a ride in time is $100?

CS

$3,000

$2,500

$800

$200

Total

15

The Demand Schedule and the

Demand Curve
The market demand curve depicts the various
quantities that buyers would be willing and able to
purchase at different prices.

16

The Demand Schedule and the

Demand Curve

Figure 1 The Demand Schedule and the Demand Curve

At any given quantity, the price given by the demand curve
reflects the marginal buyers willingness to pay.
Price of
Album
John s willingness to pay

$100

Paul s willingness to pay

80

George s willingness to pay

70

Ringo s willingness to pay

50

Demand

Quantity of Albums

Figure 2 Measuring Consumer Surplus with the Demand

Curve
Because the demand curve shows the buyers willingness to pay,
we can use the demand curve to measure consumer surplus.
(a) Price = $80
Price of
Album
$100

John s consumer surplus ($20)

80
70
50

Demand

Quantity of
Albums

Figure 2 Measuring Consumer Surplus with the Demand

Curve
The area below the demand curve and above the price measures
the consumer surplus in the market.
(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

4 Quantity of
Albums

20

Using the Demand Curve to Measure

Consumer Surplus

The area below the demand curve and

above the price measures the consumer
surplus in the market.
This applies not only to the kinked (or
steplike) demand curves.

Figure 3 How the Price Affects Consumer Surplus

(a) Consumer Surplus at Price P
Price
A

Consumer
surplus
P1

Demand

Q1

Quantity

Figure 3 How the Price Affects Consumer Surplus

As price falls, consumer surplus increases for two reasons:
a. Those already buying
the product will receive
additional consumer
surplus because they are
paying less for the
product than before.

(b) Consumer Surplus at Price P

Price

b. Since the price is now

lower, some new buyers
will enter the market and
receive consumer surplus
on these additional units
of output purchased

Initial
consumer
surplus
P1

P2

Consumer surplus
to new consumers

F
D
E
Additional consumer
surplus to initial
consumers
Q

Demand

Quantity

23

What Does Consumer Surplus Measure?

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.

A measure of consumers wellbeing

24

PRODUCER SURPLUS
Producer surplus is the amount a seller is paid for a
good minus the sellers cost.
It measures the benefit to sellers participating in a
market.

Table 2 The Costs of Four Possible Sellers

You want to hire someone to paint your house.
There are four sellers from whom you accept bids for the work.
Each painter is willing to work if the price you will pay exceeds her
opportunity cost.
Note that this opportunity cost thus represents willingness to sell.
Bidding starts at $1,000
To win the job a seller has to offer the
lowest price.
The bidding will stop when the price
drops to just below $600.
All sellers will drop out except for
Grandma.
Since Grandma receives more than she
would require to paint the house, she
derives a benefit from producing for the
market: $600-$500=$100

26

Using the Supply Curve to Measure Producer

Surplus
Just as consumer surplus is related to the demand
curve, producer surplus is closely related to the
supply curve.

27

The Supply Schedule and the

Supply Curve

Figure 4 The Supply Schedule and the Supply Curve

At any given quantity, the price given by the supply curve represents the
cost of the marginal seller.

29

Using the Supply Curve to Measure Producer

Surplus
Because the supply curve shows the sellers cost
(willingness to sell), we can use the supply curve to
measure producer surplus.
The area below the price and above the supply
curve measures the producer surplus in a market.

Figure 5 Measuring Producer Surplus with the Supply

Curve
(a) Price = $600
Price of
House
Painting

Supply

$900
800

600
500
Grandma s producer
surplus ($100)

4
Quantity of
Houses Painted

Figure 5 Measuring Producer Surplus with the Supply

Curve
(b) Price = $800
Price of
House
Painting

$900

Supply

Total
producer
surplus ($500)

800
600

Georgia s producer
surplus ($200)

500

Grandmas producer
surplus ($300)

4
Quantity of
Houses Painted

Figure 6 How the Price Affects Producer Surplus

(a) Producer Surplus at Price P
Price
Supply

P1

B
Producer
surplus

A
0

Q1

Quantity

Figure 6 How the Price Affects Producer Surplus

As price rises, producer

surplus increases for two
reasons.

(b) Producer Surplus at Price P

Price

a. Those already selling the

product will receive
additional producer surplus
because they are receiving
more for the product than
before.

P2

P1

b. Since the price is now

higher, some new sellers
will enter the market and
receive producer surplus
on these additional units of
output sold.

Supply

Additional producer
surplus to initial
producers
D

E
F

B
Initial
producer
surplus

Producer surplus
to new producers

A
0

Q1

Q2

Quantity

34

MARKET EFFICIENCY
Assume that a government equally cares about well
being of consumers and producers.
Consumer surplus and producer surplus may be
used to address the following question:
Is the allocation of resources determined by free markets
in any way desirable?
Or should the government interfere and try to improve
upon the market allocation?

35

MARKET EFFICIENCY
Consumer Surplus
= Value to buyers Amount paid by buyers
and

Producer Surplus
= Amount received by sellers Cost to sellers

36

MARKET EFFICIENCY
Total surplus
= Consumer surplus + Producer surplus =
(Value to buyers Amount paid by buyers) + (Amount received by sellers Cost to sellers)

or
Total surplus
= Value to buyers Cost to sellers

37

MARKET EFFICIENCY
Efficiency is the property of a resource allocation of
maximizing the total surplus received by all
members of society.
Is the market equilibrium efficient?

In addition to market efficiency, a government

might also care about equity the fairness of the
distribution of well-being among the various buyers
and sellers.
Is the market equilibrium equitable?

Figure 7 Consumer and Producer Surplus in the Market

Equilibrium
Price A
D

Supply

Consumer
surplus
Equilibrium
price

E
Producer
surplus

Demand

C
0

Equilibrium
quantity

Quantity

39

MARKET EFFICIENCY

Three Insights Concerning Market Outcomes

For a given market-equilibrium quantity

1. Free markets allocate the supply of goods to the buyers who
value them most highly, as measured by their willingness to
pay.
2. Free markets allocate the demand for goods to the sellers
who can produce them at least cost.

Would the society be better off if the government

chooses a different quantity by reallocating the
resources away from market equilibrium?

No. Free markets produce the quantity of goods that

maximizes the sum of consumer and producer surplus.

Figure 8 The Efficiency of the Equilibrium Quantity

a. At any quantity of output Price
smaller than the equilibrium
quantity, the value of the
product to buyers is greater
than the cost to sellers so
total surplus would rise if
the output increases.
b. At any quantity of output
greater than the equilibrium
quantity, the value of the
product to buyers is less
than the cost to sellers so
total surplus would rise if
the output decreases.

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

41

The Efficiency of the Equilibrium Quantity

Price of
Ice-Cream
Cone

Supply

3
Equilibrium
price

Demand

60 70 100
Equilibrium
quantity

Quantity of
Ice-Cream
Cones

42

Evaluating the Market Equilibrium

Because the equilibrium outcome is an efficient
allocation of resources, the government can leave
the market outcome as he/she finds it.
This policy of leaving well enough alone goes by
the French expression laissez faire.

43

Caveate: Market Failures

Market Power
If a market system is not perfectly competitive, market
power may result.
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.

44

Caveat: Market Failures

Externalities
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.
Pollution is often not taken into account in the
production decision => output is too high.

45

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.

46

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.

47

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.

48

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.