A rational decision maker makes choices so as best to achieve a clear goal. Rational behavior most often requires marginal analysis in which the marginal benefit and marginal cost of a incremental action are compared. Economists assume that consumers take actions so as to maximize their satisfaction or utility. An implication of rationality on the part of consumers is that their demand curves for a good reflect their marginal benefit from the good.

Willingness to pay is the maximum amount that a buyer is willing to pay for a good. Marginal willingness to pay (marginal benefit) is the maximum amount a buyer is willing to pay for an incremental unit. Total willingness to pay (total benefit) is the maximum amount a buyer is willing to pay for the total number of units received.

What if the price of movies tickets is $7.00 each? A consumer seeking to maximize satisfaction will choose the number of movies that maximizes her net gain or consumer surplus (for the given price). The consumer surplus associated with a particular quantity is the total one is willing to pay for that quantity of the good minus what one actually pays.

In maximizing total net benefit (i.e., consumer surplus), the individual will buy each units having a marginal benefit that is at least as great as the marginal cost.

movies $ per movie

movies $ per movie P = $7.00 $7 $5 $3 $1

P = $ movies $ per movie $7 $5 $3 $1 $3 $ movies $ per movie P = $4.00 $8 $6 $4 $10 $2

10 60 D Q P a b c consumer surplus when P = $20 (area abc): m nr consumer surplus when P = $10 (area amr): $400 initial surplus $400 increase in surplus due to price reduction on initial quantity $400 = (20-10)40 $100 increase in surplus from purchase of additional units of Q

A supply curve reflects the marginal opportunity cost of sellers making the good available. Quantity of Houses Painted Price of House Painting $ Grandma’s cost Georgia’s cost Frida’s cost Mary’s cost Supply

Measuring Producer Surplus with the Supply Curve... Quantity of Houses Painted Price of House Painting $ Supply Price = $800 Georgia’s producer surplus ($200) Total producer surplus ($500) Grandma’s producer surplus ($300)

Quantity of Houses Painted Price of House Painting $ Supply Price = $800 Producer surplus is the total amount sellers receive in payment for a good minus the sellers’ (total) opportunity cost. The area below the price and above the supply curve measures the producer surplus in a market.

P2P2 Q2Q2 How Price Affects Producer Surplus... Quantity Price 0 Supply Q1Q1 P1P1 A B C Initial Producer surplus Additional producer surplus to initial producers D E F Producer surplus to new producers

The diamond-water paradox refers to the puzzling observation that markets place a very high value on diamonds at the same time that water is cheap. Market prices reflect marginal values and marginal costs. When a good is abundant, the marginal value of the last unit can be quite low even though the total net benefit (i.e., consumer surplus) is quite large. D S Q P P1P1 Q1Q1 However, in reality there is no paradox of value.

Welfare Economics Welfare economics is the study of how the allocation of resources affects economic well-being. uBuyers and sellers receive benefits from taking part in the market. uConsumer surplus measures economic welfare on the buyer’s side. uProducer surplus measures economic welfare on the seller’s side.

Total Surplus consumer surplus = value to buyers - amount paid producer surplus = amount paid - costs to sellers total surplus = consumer surplus + producer surplus = value to buyers - costs to sellers

Welfare economics is concerned with both efficiency and equity. Efficiency is concerned with maximizing the total surplus received by all members of society. Equity is concerned with the fairness of the distribution of well-being among the members of society.

For an allocation of resources to be efficient, each of the following is needed: Efficiency in production: Any given level of output must be produced in the least costly manner. Efficiency in exchange: Any given level of output must be consumed by those individuals who value it the most. Efficiency in the mix and levels of goods and services

Q D SP Q0Q0 P0P0 qaqa sasa P P0P0 q0aq0a qbqb sbsb P P0P0 q0bq0b qeqe sese P P0P0 q0eq0e qcqc scsc P P0P0 q0cq0c Free markets result in the total output produced, here Q 0, being produced by the sellers who can produce at the least cost. In this way, the given level of output is produced in the least costly manner.

Q D SP Q0Q0 P0P0 qhqh dhdh P P0P0 q0hq0h qiqi didi P P0P0 q0iq0i qjqj djdj P P0P0 q0jq0j Free markets result in the total output produced, here Q 0, being allocated to buyers who value the good most highly. In this way, for the given level of output the total benefit to buyers is maximized. qkqk P P0P0 q0kq0k dkdk

Free markets produce the quantity of goods, here Q 0, that maximize the sum of producer and consumer surplus. Q D S P Q0Q0 P0P0 consumer surplus producer surplus

Q D SP Q0Q0 P0P0 Producing any units of Q greater than Q 0, will result in a fall in total surplus since the marginal cost to sellers exceed the marginal value to buyers. Q2Q2 a b c e f

Q D SP Q0Q0 P0P0 Reducing Q to a level below Q 0 would result in a reduction in total surplus since the marginal cost of those units to sellers is less than the marginal value of those units to buyers. Q1Q1 a b c m n

Even though buyers and sellers are only concerned about their own (individual) welfare, demand and supply forces in competitive markets operate like an “invisible hand,” leading to the total benefit to buyers and sellers being maximized. Quotes from Adam Smith in The Wealth of Nations “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.” “Every individual … by pursuing his own interest.. promotes that of society. He is led … by an invisible hand to promote an end which was no part of his intention.”

Problems impeding the functioning of markets: Lack of competition: Competition in markets often is less than perfect. Externalities: when the actions of either buyers or sellers affect third parties, maximizing the total benefits to buyers and sellers is not not the same as maximizing the total surplus or net benefit to society. In general, there is market failure when unregulated markets fail to allocate resources efficiently.