3 supply and demand ii: markets and welfare. 7 consumers, producers, and the efficiency of markets

3

SUPPLY AND DEMAND II: MARKETS AND WELFARE

7

Consumers, Producers, and the Efficiency of Markets

CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 3

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.


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


Welfare Economics: two main concepts

• Consumer surplus measures economic welfare of the buyer.

• Producer surplus measures economic welfare of the seller.


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.

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


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


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”


Table 1 Four Possible Buyers’ Willingness to Pay

For a mint-condition recording of Elvis Presley’s first album

11

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 to Pay

Consumer Surplus

Buy?

John 100 25 Yes

Paul 80 5 Yes

George 70 -5 No

Ringo 50 -25 No

CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS12

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

13

The Demand ScheduleBuyer Willingness

to Pay

John 100

Paul 80

George 70

Ringo 50

Figure 1 The Demand Curve

Copyright©2003 Southwestern/Thomson Learning

Price ofAlbum

0 Quantity ofAlbums

Demand

1 2 3 4

$100 John’s willingness to pay

80 Paul’s willingness to pay

70 George’s willingness to pay

50 Ringo’s willingness to pay


John 100

Paul 80

George 70

Ringo 50

The height of the demand curve at any quantity shows the willingness to pay of whoever bought the last unit.


Area of a Rectangle

Height

Width

Area = Width × Height

Figure 2 Measuring Consumer Surplus with the Demand Curve

(a) Price = $80.01

Price ofAlbum

50

70

80

0

$100

Demand

1 2 3 4 Quantity ofAlbums

John’s willingness to pay ($100)


Consumer Surplus

Buy?

John 100 20 Yes

Paul 80 0 No

George 70 -10 No

Ringo 50 -30 No

1. The area under the demand curve measures the total willingness to pay for the quantity demanded.

2. It is also the maximum willingness to pay that could be generated from that quantity.


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


John 100

Paul 80

George 70

Ringo 50

Figure 2 Measuring Consumer Surplus with the Demand Curve

(b) Price = $70.01Price of

Album

50

70

80

0

$100

Demand

1 2 3 4 Quantity ofAlbums


Consumer Surplus

Buy?

John 100 30 Yes

Paul 80 10 Yes

George 70 0 No

Ringo 50 -20 No

John’s willingness to pay Paul’s willingness to pay

1. The area under the demand curve measures the total willingness to pay for the quantity demanded.

2. It is also the maximum willingness to pay that could be generated from that quantity.

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


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



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


John 100

Paul 80

George 70

Ringo 50

Willingness to Pay from the Demand Curve

Quantity

(a) Willingness to Pay at Price P

Price

0

Demand

P1

Q1

B

A

C

The area under the demand curve also measures the maximum willingness to pay that could be obtained from Q1 units


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.

Figure 3 How the Price Affects Consumer Surplus

Consumersurplus

Quantity

(a) Consumer Surplus at Price P

Price

0

Demand

P1

Q1

B

A

C

Total Payment

Consumer Surplus (ABC) + Total Payment (OBCQ1) = Willingness to Pay (OACQ1)


Using the Demand Curve to Measure Consumer Surplus

• In general, the area below the demand curve and above the price measures the consumer surplus.

Figure 3 How the Price Affects Consumer Surplus

Initialconsumer

surplus

Quantity

(b) Consumer Surplus at Price P

Price

0

Demand

A

BC

D EF

P1

Q1

P2

Q2

Consumer surplusto new consumers

Additional consumersurplus to initial consumers

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?


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.



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


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.

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

Figure 4 The Supply Schedule and the Supply Curve

Seller Cost ($)

Mary 900

Frida 800

Georgia 600

Grandma 500

The height of the supply curve at any quantity shows the production cost to whoever produces the last unit.


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

Georgia 600 100 Yes

Grandma 500 200 Yes


Using the Supply Curve to Measure Producer Surplus• The area below the price and above the

supply curve measures the producer surplus.

Figure 5 Measuring Producer Surplus with the Supply Curve

Quantity ofHouses Painted

Price ofHouse

Painting

500

800

$900

0

600

1 2 3 4

(a) Price = $599.99

Supply

Grandma’s Cost ($500)


Sell?

Mary 900 -300 No

Frida 800 -200 No

Georgia 600 0 No

Grandma 500 100 Yes

1. The area under the supply curve is the cost of the quantity supplied

2. It is also the lowest cost for that quantity


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

Figure 5 Measuring Producer Surplus with the Supply Curve

Quantity ofHouses Painted

Price ofHouse

Painting

500

800

$900

0

600

1 2 3 4

(b) Price = $799.99

Supply


Sell?

Mary 900 -100 No

Frida 800 0 No

Georgia 600 200 Yes

Grandma 500 300 Yes

Grandma’s costGeorgia’s cost

1. The area under the supply curve is the cost of the quantity supplied

2. It is also the lowest cost for that quantity


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

Figure 6 How the Price Affects Producer Surplus

Producersurplus

Quantity

(a) Producer Surplus at Price P

Price

0

Supply

B

A

C

Q1

P1

Production Cost

Total Revenue (OBCQ1) =Production Cost (OACQ1) + Producer Surplus (ABC)

Figure 6 How the Price Affects Producer Surplus

Quantity

(b) Producer Surplus at Price P

Price

0

P1B

C

Supply

A

Initialproducersurplus

Q1

P2

Q2

Producer surplusto new producers

Additional producersurplus to initialproducers

D EF


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?


MARKET EFFICIENCY

Consumer Surplus

= Value to buyers – Amount paid by buyers

and

Producer Surplus

= Amount received by sellers – Cost to sellers


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

MARKET EFFICIENCY

• In fact, we can go further and say that

• Total Surplus = maximum willingness to pay – minimum production cost



MARKET EFFICIENCY

• An economic outcome is efficient if there is no feasible way to make the total surplus any higher.

Figure 7 Consumer and Producer Surplus in the Market Equilibrium

Producersurplus

Consumersurplus

Price

0 Quantity

Equilibriumprice

Equilibriumquantity

Supply

Demand

A

C

B

D

E

Cost

Consumersurplus

Figure 7 Consumer and Producer Surplus in the Market Equilibrium

Producersurplus

Price

0 Quantity

Equilibriumprice

Equilibriumquantity

Supply

Demand

A

C

B

D

E

Total Value (or, willingness to pay)

Total Surplus

Cost (also, Minimum Cost)

Consumersurplus

The best feasible outcome

Producersurplus

Price

0 Quantity

Equilibriumprice

Equilibriumquantity

Supply

Demand

A

C

B

D

E

Total Value (also, Maximum Value)

Maximum Total Surplus

As long as we produce the equilibrium quantity, it would be impossible to increase the Total Surplus by reallocating production and consumption.

But is the equilibrium output the right output to produce?

Maximum Cost saved


Price

0 Quantity

Equilibriumprice

Equilibriumquantity

Supply

Demand

A

C

B

D

E

Minimum WTP lost

Alternative

Society would be worse off if it produces less than the equilibrium quantity

Minimum Cost


Price

0 Quantity

Equilibriumprice

Equilibriumquantity

Supply

Demand

A

C

B

D

E

Society would be worse off if it produces more than the equilibrium quantity

Maximum Value of extra output

Alternative


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.

Figure 8 The Efficiency of the Equilibrium Quantity

Quantity

Price

0

Supply

Demand

Costto

sellers

Costto

sellers

Valueto

buyers

Valueto

buyers

Value to buyers is greaterthan cost to sellers.

Value to buyers is lessthan cost to sellers.

Equilibriumquantity


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.


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


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

http://en.wikipedia.org/wiki/Ticket_resale


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

WHEN MARKETS FAIL



However, markets can go wrong

• Market Power

• Externalities

• Fairness


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.


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.


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

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


Video: Scroogenomics

• Heard the one about the economist who gave cash as a Valentines Day gift?– Scrooge alert: Your holiday spending may res

ult in an economic loss by Paul Solman, PBS Newshour, December 23, 2013.


http://www.pbs.org/newshour/bb/business/july-dec13/giving_12-23.html




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.


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.


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.


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.

3 supply and demand ii: markets and welfare. 7 consumers, producers, and the efficiency of markets

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