© 2011 Thomson South-Western

Welfare economics is the study of how the allocation of resources affects economic well- being.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.Buyers and sellers receive benefits from taking part in the market. The equilibrium in a market maximizes the total welfare of buyers and sellers.The equilibrium in a market maximizes the total welfare of buyers and sellers. Welfare Economics

© 2011 Thomson South-Western CONSUMER SURPLUS Willingness to pay (WTP) is the maximum amount that a buyer will pay for a good.Willingness to pay (WTP) is the maximum amount that a buyer will pay for a good. It measures how much the buyer values the good or service.It measures how much the buyer values the good or service.

© 2011 Thomson South-Western CONSUMER SURPLUS Consumer surplus isConsumer surplus is –the buyer’s willingness to pay for a good minus –the amount the buyer actually pays for it.

© 2011 Thomson South-Western Figure 3 How the Price Affects Consumer Surplus Consumer surplus Quantity (a) Consumer Surplus at Price P Price 0 Demand P1P1 Q1Q1 B A C

© 2011 Thomson South-Western Figure 3 How the Price Affects Consumer Surplus Initial consumer surplus Quantity (b) Consumer Surplus at Price P Price 0 Demand A B C DE F P1P1 Q1Q1 P2P2 Q2Q2 Consumer surplus to new consumers Additional consumer surplus to initial consumers

© 2011 Thomson South-Western What Does Consumer Surplus Measure? Consumer surplus:Consumer surplus: the amount that buyers are willing to pay for a good minus the amount they actually pay for it;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.measures the benefit that buyers receive from a good as the buyers themselves perceive it.

© 2011 Thomson South-Western A C T I V E L E A R N I N G 1 : Consumer surplus P $ Q Demand curve A. Find marginal buyer’s WTP at Q = 10. B. Find CS for P = $30. Suppose P falls to $20. How much will CS increase due to… C. buyers entering the market D. existing buyers paying lower price

© 2011 Thomson South-Western A C T I V E L E A R N I N G 1 : Answers P $ Q Demand curve A. At Q = 10, marginal buyer’s WTP is $30. B. CS = ½ x 10 x $10 = $50 P falls to $20. C. CS for the additional buyers = ½ x 10 x $10 = $50 D. Increase in CS on initial 10 units = 10 x $10 = $100

© 2011 Thomson South-Western PRODUCER SURPLUS Producer surplus is the amount a seller is paid for a good minus the seller’s cost.Producer surplus is the amount a seller is paid for a good minus the seller’s cost. –Cost here includes opportunity cost All out of pocket costs plus time costsAll out of pocket costs plus time costs It measures the benefit to sellers participating in a market.It measures the benefit to sellers participating in a market.

© 2011 Thomson South-Western Figure 6 How the Price Affects Producer Surplus Producer surplus Quantity (a) Producer Surplus at Price P Price 0 Supply B A C Q1Q1 P1P1

© 2011 Thomson South-Western Figure 6 How the Price Affects Producer Surplus Quantity (b) Producer Surplus at Price P Price 0 P1P1 B C Supply A Initial producer surplus Q1Q1 P2P2 Q2Q2 Producer surplus to new producers Additional producer surplus to initial producers D E F

© 2011 Thomson South-Western A C T I V E L E A R N I N G 2 : Producer Surplus P Q Supply curve A. Find marginal seller’s cost at Q = 10. B. Find PS for P = $20. Suppose P rises to $30. Find the increase in PS due to… C. selling 5 additional units D. getting a higher price on the initial 10 units

© 2011 Thomson South-Western A C T I V E L E A R N I N G 2 : Answers P Q Supply curve A. At Q = 10, marginal cost = $20 B. PS = ½ x 10 x $20 = $100 P rises to $30. C. PS on additional units = ½ x 5 x $10 = $25 D. Increase in PS on initial 10 units = 10 x $10 = $100

© 2011 Thomson South-Western MARKET EFFICIENCY Consumer surplus and producer surplus may be used to address the following question: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?

© 2011 Thomson South-Western The Benevolent Social Planner Consumer Surplus = Value to buyers – Amount paid by buyers and Producer Surplus = Amount received by sellers – Cost to sellers

© 2011 Thomson South-Western The Benevolent Social Planner 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) Total surplus = Value to buyers – Cost to sellers

© 2011 Thomson South-Western The Benevolent Social Planner Efficiency is the property of a resource allocation of maximizing the total surplus received by all members of society.Efficiency is the property of a resource allocation of maximizing the total surplus received by all members of society.

© 2011 Thomson South-Western The Benevolent Social Planner 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.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.

© 2011 Thomson South-Western Figure 7 Consumer and Producer Surplus in the Market Equilibrium Producer surplus Consumer surplus Price 0 Quantity Equilibrium price Equilibrium quantity Supply Demand A C B D E

© 2011 Thomson South-Western Evaluating the Market Equilibrium Three Insights Concerning Market OutcomesThree Insights Concerning Market Outcomes Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay.Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay. Free markets allocate the demand for goods to the sellers who can produce them at least cost.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.Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.

© 2011 Thomson South-Western Which Buyers Get to Consume the Good? P Q S D Every buyer whose WTP is ≥ $30 will buy. Every buyer whose WTP is < $30 will not. So, the buyers who value the good most highly are the ones who consume it.

© 2011 Thomson South-Western Which Sellers Produce the Good? P Q S D Every seller whose cost is ≤ $30 will produce the good. Every seller whose cost is > $30 will not. Hence, the sellers with the lowest cost produce the good.

© 2011 Thomson South-Western Does Eq’m Q Maximize Total Surplus? P Q S D At Q = 20, cost of producing the marginal unit is $35 value to consumers of the marginal unit is only $20 Hence, can increase total surplus by reducing Q. This is true at any Q greater than 15.

© 2011 Thomson South-Western Does Eq’m Q Maximize Total Surplus? P Q S D At Q = 10, cost of producing the marginal unit is $25 value to consumers of the marginal unit is $40 Hence, can increase total surplus by increasing Q. This is true at any Q less than 15.

© 2011 Thomson South-Western Figure 8 The Efficiency of the Equilibrium Quantity Quantity Price 0 Supply Demand Cost to sellers Cost to sellers Value to buyers Value to buyers Value to buyers is greater than cost to sellers. Value to buyers is less than cost to sellers. Equilibrium quantity

© 2011 Thomson South-Western Evaluating the Market Equilibrium Because the equilibrium outcome is an efficient allocation of resources, the social planner can leave the market outcome as he/she finds it.Because the equilibrium outcome is an efficient allocation of resources, the social planner can leave the market outcome as he/she finds it. This policy of leaving well enough alone goes by the French expression laissez faire.This policy of leaving well enough alone goes by the French expression laissez faire.