N.

GREGORY MANKIW
PRINCIPLES OF

ECONOMICS
Eight Edition

CHAPTER Consumers, Producers, and

the Efficiency of Markets
7
Premium PowerPoint Slides by:
V. Andreea CHIRITESCU
Eastern Illinois University

1
 Welfare Economics
• Allocation of resources refers to:
– How much of each good is produced
– Which producers produce it
– Which consumers consume it
• Welfare economics
– Studies how the allocation of resources
affects economic well-being

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 Willingness to Pay (WTP)
• A buyer’s willingness to pay for a good
– Maximum amount the buyer will pay for
that good
– How much the buyer values the good
name WTP
Example:
Anthony $250 4 buyers’ WTP
Chad 175 for an iPod
Flea 300
John 125
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 WTP and the Demand Curve

Q: If price of iPod is $200, who will buy an

iPod, and what is quantity demanded?

name WTP A: Anthony & Flea will buy an

iPod, Chad & John will not.
Anthony $250
Hence, Qd = 2
Chad 175 when P = $200.
Flea 300
John 125
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 WTP and the Demand Curve
• Derive the
P (price
demand of iPod)
who buys Qd
schedule:
$301 & up nobody 0

251 – 300 Flea 1

name WTP
176 – 250 Anthony, Flea 2
Anthony $250
Chad, Anthony,
Chad 175 126 – 175 3
Flea
Flea 300 John, Chad,
0 – 125 4
John 125 Anthony, Flea
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WTP and the Demand Curve
P
$350
P Qd
$300
$250 $301 & up 0

$200 251 – 300 1

$150 176 – 250 2
$100
126 – 175 3
$50
0 – 125 4
$0
Q
0 1 2 3 4
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About the Staircase Shape…
This D curve looks like a
P staircase with 4 steps –
$350 one per buyer.
$300
If there were a huge # of
$250 buyers, as in a
$200 competitive market, there
would be a huge # of
$150 very tiny steps, and it
would look more like a
$100
smooth curve.
$50
$0
Q
0 1 2 3 4
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WTP and the Demand Curve
P Flea’s WTP At any Q, the height
$350 of the D curve is the
$300 Anthony’s WTP WTP of the
$250 Chad’s WTP marginal buyer,
$200 the buyer who
John’s
$150 WTP would leave the
market if P were
$100
any higher.
$50
$0
Q
0 1 2 3 4
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 Consumer Surplus (CS)
• Consumer surplus CS = WTP – P
– Amount a buyer is willing to pay minus the
amount the buyer actually pays:

name WTP Suppose P = $260.

Anthony $250 Flea’s CS = $300 – 260 = $40.
Chad 175 The others get no CS because they
do not buy an iPod at this price.
Flea 300
Total CS = $40.
John 125
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CS and the Demand Curve
P P = $260
Flea’s WTP
$350
Flea’s CS =
$300 $300 – 260 = $40
$250 Total CS = $40
$200
$150
$100
$50
$0
Q
0 1 2 3 4
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CS and the Demand Curve
Instead, suppose P = $220
P
Flea’s WTP Flea’s CS = $300 – 220 = $80
$350
$300 Anthony’s WTP
Anthony’s CS = $250 – 220 =
$250 $30
$200 Total CS = $110
$150 Total CS equals the
$100 area under the
demand curve
$50 above the price, from
$0 0 to Q.
Q
0 1 2 3 4
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 CS with Lots of Buyers & a Smooth D Curve
Price
per pair P The demand for shoes
$ 60
At Q = 5 (thousand), 50
the marginal buyer is
40
willing to pay $50 for
pair of shoes. 30
Suppose P = $30. 1000s of pairs
20 of shoes
Then his consumer
surplus = $20. 10
D
0 Q
0 5 10 15 20 25 30
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CS with Lots of Buyers & a Smooth D Curve
CS is the area
between P and the P The demand for shoes
D curve, from 0 to Q.
$ 60
Recall: area of 50
a triangle equals h
40
½ x base x height
30
Height =
20
$60 – 30 = $30.
So, 10
CS = ½ x 15 x $30 D
0 Q
= $225.
0 5 10 15 20 25 30
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How a Higher Price Reduces CS

P If P rises to $40,
60 CS = ½ x 10 x $20
1. Fall in CS
= $100.
due to buyers 50
leaving market Two reasons for
40 the fall in CS.
30

2. Fall in CS due to 20
remaining buyers 10
paying higher P D
0 Q
0 5 10 15 20 25 30
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Active Learning 1 Consumer surplus
A. Find marginal buyer’s 50
P
demand curve
WTP at Q = 10. $ 45
B. Find CS for P = $30 40
35
Suppose P falls to $20. 30
How much will CS
25
increase due to…
20
C. buyers entering 15
the market 10
D. existing buyers 5
paying lower price 0
0 5 10 15 20 Q
25
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 Active Learning 1 Answers
A. At Q = 10, marginal P
50
demand curve
buyer’s WTP is $30. $45
B. CS = ½ x 10 x $10 40
= $50 35
30
P falls to $20.
25
C. CS for the
20
additional buyers
= ½ x 10 x $10 = $50 15
10
D. Increase in CS
on initial 10 units 5
= 10 x $10 = $100 0
0 5 10 15 20 Q
25
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 Producer Surplus
• Cost
– Value of everything a seller must give up to
produce a good
• Measure of willingness to sell: produce and
sell the good/service only if the price > cost

name cost Example: Costs of 3

Jack $10 sellers in the lawn-cutting
business.
Janet 20
Chrissy 35
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 Producer Surplus
• Derive the supply
P Qs
schedule from the
cost data: $0 – 9 0

10 – 19 1

20 – 34 2
name cost
35 & up 3
Jack $10
Janet 20
Chrissy 35
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Cost and the Supply Curve

P
$40 P Qs

$0 – 9 0
$30
10 – 19 1
$20
20 – 34 2

$10 35 & up 3

$0
Q
0 1 2 3
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Cost and the Supply Curve

P At each Q, the
height of the S
$40
Chrissy’s curve is the cost
cost of the marginal
$30
seller, the seller
Janet’s who would leave
$20 cost the market if the
price were any
$10 Jack’s cost lower.

$0 Q
0 1 2 3
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 Producer Surplus
• Producer surplus, PS = P - cost
– Amount a seller is paid for a good minus
the seller’s cost of providing it
– Price received minus willingness to sell

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Producer Surplus and the S Curve
PS = P – cost
P
Suppose P = $25.
$40
Chrissy’s Jack’s PS = $15
cost
$30 Janet’s PS = $5
Janet’s
$20 cost Chrissy’s PS = $0
Total PS = $20
$10 Jack’s cost
Total PS equals the area
$0 above the supply curve
0 1 2 3 Q under the price, from 0 to Q.
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 PS with Lots of Sellers & a Smooth S Curve

Price P The supply of shoes

per pair
60
Suppose P = $40. 50 S

At Q = 15(thousand), 40
the marginal seller’s 30
cost is $30, 1000s of pairs
and her producer 20 of shoes
surplus is $10. 10
0 Q
0 5 10 15 20 25 30
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PS with Lots of Sellers & a Smooth S Curve

PS is the area P The supply of shoes

between P and the S
60
curve, from 0 to Q.
50 S
The height of this
triangle is 40
$40 – 15 = $25.
30
So, h
20
PS = ½ x b x h
= ½ x 25 x $25 10
= $312.50
0 Q
0 5 10 15 20 25 30
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How a Lower Price Reduces PS

If P falls to $30,
P 1. Fall in PS
PS = ½ x 15 x $15 60 due to sellers
= $112.50 leaving market
50 S
Two reasons for
the fall in PS. 40
30

2. Fall in PS due to 20
remaining sellers 10
getting lower P
0 Q
0 5 10 15 20 25 30
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Active Learning 1 Producer surplus
A. Find marginal seller’s P
50
supply curve
cost at Q = 10. 45
B. Find total PS for P = 40
$20. 35
Suppose P rises to $30. 30
Find the increase in PS 25
due to: 20
C. selling 5 additional 15
units 10
D. getting a higher price 5
on the initial 10 units 0
0 5 10 15 20 Q25
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 Active Learning 1 Producer surplus
P
50
A. At Q = 10, supply curve
45
marginal cost = $20
40
B. PS = ½ x 10 x $20
35
= $100
30
P rises to $30. 25
C. PS on 20
additional units 15
= ½ x 5 x $10 = $25 10
D. Increase in PS 5
on initial 10 units 0
= 10 x $10 = $100
0 5 10 15 20 Q25
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 Market Efficiency
• Total surplus = CS + PS
– Consumer surplus = Value to buyers –
Amount paid by buyers
• Buyers’ gains from participating in the market
– Producer surplus = Amount received by
sellers – Cost to sellers
• Sellers’ gains from participating in the market
Total surplus = Value to buyers – Cost to sellers

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 Market’s Allocation of Resources
• Allocation of resources – desirable?
– Decentralized (in a market economy)
• Determined by interactions of many self-
interested buyers and sellers
– Total surplus – measure of society’s well-
being
• To consider whether the market’s allocation is
efficient

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 Market’s Allocation of Resources
• Efficient allocation of resources
maximizes total surplus
1. The goods are consumed by the buyers
who value them most highly
2. The goods are produced by the
producers with the lowest costs
3. Raising or lowering the quantity of a
good would not increase total surplus

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Evaluating the Market Equilibrium

Market equilibrium: P
P = $30
60
Q = 15 (thousand)
Total surplus 50 S
= CS + PS
40 CS
Is the market 30
equilibrium efficient? PS
20
10
D
0 Q
0 5 10 15 20 25 30
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Which Buyers Consume the Good?

Every buyer whose

P
WTP is ≥ $30 will
buy. 60
50 S
Every buyer whose
WTP is < $30 will not. 40
30
20
The buyers who
value the good most 10
D
highly are the ones 0 Q
who consume it. 0 5 10 15 20 25 30
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Which Sellers Produce the Good?

Every seller whose P

cost is ≤ $30 will 60
produce the good.
50 S
Every seller whose 40
cost is > $30 will 30
not.
20
The sellers with 10
the lowest cost D
0 Q
produce the good.
0 5 10 15 20 25 30
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Does Equilibrium Q Maximize Total Surplus?

At Q = 20, cost of
P
producing the
marginal unit is $35 60

value to consumers 50 S
of the marginal unit is 40
only $20
30
Hence, can increase
total surplus by 20
reducing Q. 10
D
This is true at any Q 0 Q
greater than 15. 0 5 10 15 20 25 30
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Does Equilibrium Q Maximize Total Surplus?

At Q = 10, cost of
P
producing the
marginal unit is $25 60

value to consumers 50 S
of the marginal unit is 40
$40
30
Hence, can increase
total surplus by 20
increasing Q. 10
D
This is true at any Q 0 Q
less than 15. 0 5 10 15 20 25 30
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 Adam Smith and the Invisible Hand
Passages from The Wealth of Nations, 1776
“Man has almost constant occasion for the
help of his brethren, and it is vain for him
to expect it from their benevolence only.
He will be more likely to prevail if he can
interest their self-love in his favor, and
show them that it is for their own
©Georgios Kollidas/Shutterstock.com
advantage to do for him what he requires
Adam Smith,
of them… 1723-1790
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….
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 Adam Smith and the Invisible Hand
Passages from The Wealth of Nations, 1776
“Every individual…neither intends to
promote the public interest, nor knows
how much he is promoting it….
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
©Georgios Kollidas/Shutterstock.com
was no part of his intention. Adam Smith,
Nor is it always the worse for the society 1723-1790

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.”
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 Market Efficiency
• Adam Smith’s invisible hand
– Takes all the information about buyers
and sellers into account
– Guides everyone in the market to the best
outcome
– Economic efficiency
• Free markets
– Best way to organize economic activity

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 Market Efficiency & Market Failure
• Forces of supply and demand
– Allocate resources efficiently
• Assumptions about how markets work
1. Markets are perfectly competitive
2. Outcome in a market matters only to the
buyers and sellers in that market
• When these assumptions do not hold
– “Market equilibrium is efficient” may no
longer be true
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 Market Efficiency & Market Failure
• Market failures
– Market power: a single buyer or seller
(small group) control market prices
• Markets are inefficient
– Externalities: decisions of buyers and
sellers affect people who are not
participants in the market at all
• Inefficient equilibrium - from the standpoint of
society as a whole

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