M ARKET E FFICIENCY Economics 101

W ELFARE E CONOMICS 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. The equilibrium in a market maximizes the total welfare of buyers and sellers.

E CONOMIC W ELFARE Consumer surplus measures economic welfare from the buyer ’ s side. Producer surplus measures economic welfare from the seller ’ s side.

W ILLINGNESS TO P AY Willingness to pay is the maximum amount that a buyer will pay for a good. It measures how much the buyer values the good or service (marginal benefit).

C ONSUMER S URPLUS 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.

D EMAND S CHEDULE

F IGURE 1 T HE D EMAND S CHEDULE AND THE D EMAND C URVE Copyright©2003 Southwestern/Thomson Learning Price of Album 0Quantity of Albums Demand 1234 $100 John’s willingness to pay 80 Paul’s willingness to pay 70 George’s willingness to pay 50 Ringo’s willingness to pay

F IGURE 2 M EASURING C ONSUMER S URPLUS WITH THE D EMAND C URVE Copyright©2003 Southwestern/Thomson Learning (a) Price = $80 Price of Album $100 Demand 1234 Quantity of Albums John’s consumer surplus ($20)

F IGURE 2 M EASURING C ONSUMER S URPLUS WITH THE D EMAND C URVE Copyright©2003 Southwestern/Thomson Learning (b) Price = $70 Price of Album $100 Demand 1234 Total consumer surplus ($40) Quantity of Albums John’s consumer surplus ($30) Paul’s consumer surplus ($10)

D EMAND C URVE AND C ONSUMER S URPLUS The area below the demand curve and above the price measures the consumer surplus in the market.

F IGURE 3 H OW THE P RICE A FFECTS C ONSUMER S URPLUS Copyright©2003 Southwestern/Thomson Learning Consumer surplus Quantity (a) Consumer Surplus at Price P Price 0 Demand P1P1 Q1Q1 B A C

F IGURE 3 H OW THE P RICE A FFECTS C ONSUMER S URPLUS Copyright©2003 Southwestern/Thomson Learning 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

P RODUCER S URPLUS Producer surplus is the amount a seller is paid for a good minus the seller ’ s cost. It measures the benefit to sellers participating in a market.

S UPPLY S CHEDULE

F IGURE 5 M EASURING P RODUCER S URPLUS WITH THE S UPPLY C URVE Copyright©2003 Southwestern/Thomson Learning Quantity of Houses Painted Price of House Painting $ (a) Price = $600 Supply Grandma’s producer surplus ($100)

F IGURE 5 M EASURING P RODUCER S URPLUS WITH THE S UPPLY C URVE Copyright©2003 Southwestern/Thomson Learning Quantity of Houses Painted Price of House Painting $ (b) Price = $800 Georgia’s producer surplus ($200) Total producer surplus ($500) Grandma’s producer surplus ($300) Supply

S UPPLY C URVE AND P RODUCER S URPLUS The area below the price and above the supply curve measures the producer surplus in a market.

F IGURE 6 H OW THE P RICE A FFECTS P RODUCER S URPLUS Copyright©2003 Southwestern/Thomson Learning Producer surplus Quantity (a) Producer Surplus at Price P Price 0 Supply B A C Q1Q1 P1P1

F IGURE 6 H OW THE P RICE A FFECTS P RODUCER S URPLUS Copyright©2003 Southwestern/Thomson Learning 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

F ORMULAS Consumer Surplus = Value to buyers – Amount paid by buyers and Producer Surplus = Amount received by sellers – Cost

T OTAL S URPLUS Total surplus = Consumer surplus + Producer surplus or Total surplus = Value to buyers – Cost to sellers

M ARKET E FFICIENCY Efficiency is the property of a resource allocation of maximizing the total surplus received by all members of society. 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.

F IGURE 7 C ONSUMER AND P RODUCER S URPLUS IN THE M ARKET E QUILIBRIUM Copyright©2003 Southwestern/Thomson Learning Producer surplus Consumer surplus Price 0 Quantity Equilibrium price Equilibrium quantity Supply Demand A C B D E

I NSIGHTS Three 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 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.

F IGURE 8 T HE E FFICIENCY OF THE E QUILIBRIUM Q UANTITY Copyright©2003 Southwestern/Thomson Learning 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

LAISSEZ FAIRE 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.