3 SUPPLY AND DEMAND II: MARKETS AND WELFARE

Copyright © 2004 South-Western 7 Consumers, Producers, and the Efficiency of Markets

Copyright © 2004 South-Western REVISITING THE MARKET EQUILIBRIUM ? Do the equilibrium price and quantity maximize the total welfare of buyers and sellers? /

Copyright © 2004 South-Western Welfare Economics Welfare economics is the study of how the allocation of resources affects economic well- being. 1.Buyers and sellers receive benefits from taking part in the market. 2.The equilibrium in a market maximizes the total welfare of buyers and sellers.

Copyright © 2004 South-Western Welfare Economics Consumer surplus measures economic welfare from the buyer’s side. Producer surplus measures economic welfare from the seller’s side.

Copyright © 2004 South-Western CONSUMER SURPLUS 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.

Copyright © 2004 South-Western CONSUMER SURPLUS 1 Calculation of Consumer surplus Consumer surplus is the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it. Consumer surplus= buyer’s willingness - amount the buyer actually pays

Table 1 Four Possible Buyers’ Willingness to Pay Copyright©2004 South-Western

CONSUMER SURPLUS The market demand curve depicts the various quantities that buyers would be willing and able to purchase at different prices.

Copyright © 2004 South-Western The Demand Schedule and the Demand Curve

Figure 1 The Demand Schedule and the Demand Curve 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

Figure 2 Measuring Consumer Surplus with the Demand Curve Copyright©2003 Southwestern/Thomson Learning (a) Price = $80 Price of Album $100 Demand 1234 Quantity of Albums John’s consumer surplus ($20)

Figure 2 Measuring Consumer Surplus with the Demand Curve 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)

Copyright © 2004 South-Western Using the Demand Curve to Measure Consumer Surplus The area below the demand curve and above the price measures the consumer surplus in the market.

Figure 3 How the Price Affects Consumer Surplus Copyright©2003 Southwestern/Thomson Learning Consumer surplus Quantity (a) Consumer Surplus at Price P Price 0 Demand P1P1 Q1Q1 B A C The area below the demand curve and above the price measures the consumer surplus in the market.

Copyright © 2004 South-Western HOW A LOWER PRICE RAISES CONSUMER SURPLUS

Figure 3 How the Price Affects Consumer Surplus 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

Copyright © 2004 South-Western What Does Consumer Surplus Measure? 2 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.

Copyright © 2004 South-Western PRODUCER SURPLUS 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.

Table 2 The Costs of Four Possible Sellers Copyright©2004 South-Western

Using the Supply Curve to Measure Producer Surplus Just as consumer surplus is related to the demand curve, producer surplus is closely related to the supply curve.

Copyright © 2004 South-Western The Supply Schedule and the Supply Curve

Figure 4 The Supply Schedule and the Supply Curve

Copyright © 2004 South-Western Using the Supply Curve to Measure Producer Surplus The area below the price and above the supply curve measures the producer surplus in a market.

Copyright © 2004 South-Western USING THE SUPPLY CURVE TO MEASURE PRODUCER SURPLUS

Figure 5 Measuring Producer Surplus with the Supply Curve Copyright©2003 Southwestern/Thomson Learning Quantity of Houses Painted Price of House Painting $ (a) Price = $600 Supply Grandma’s producer surplus ($100) The area below the price and above the supply curve measures the producer surplus in a market.

Figure 5 Measuring Producer Surplus with the Supply Curve 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

Figure 6 How the Price Affects Producer Surplus Copyright©2003 Southwestern/Thomson Learning Producer surplus Quantity (a) Producer Surplus at Price P Price 0 Supply B A C Q1Q1 P1P1

Copyright © 2004 South-Western HOW A HIGHER PRICE RAISES PRODUCER SURPLUS

Figure 6 How the Price Affects Producer Surplus 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 The area below the price and above the supply curve measures the producer surplus in a market.

Copyright © 2004 South-Western MARKET EFFICIENCY Efficiency is the property of a resource allocation of maximizing the total surplus received by all members of society.

Copyright © 2004 South-Western MARKET EFFICIENCY Consumer Surplus = Value to buyers – Amount paid by buyers and Producer Surplus = Amount received by sellers – Cost to sellers

Copyright © 2004 South-Western MARKET EFFICIENCY Total surplus = Consumer surplus + Producer surplus or Total surplus = Value to buyers – Cost to sellers

Copyright © 2004 South-Western EVALUATING THE MARKET EQUILIBRIU

Copyright © 2004 South-Western To answer these questions, keep in mind that when a market is in equilibrium, the price determines which buyers and sellers participate in the market. - Is this equilibrium allocation of resources efficient? Does it maximize total surplus?

Copyright © 2004 South-Western Figure 7 Consumer and Producer Surplus in the Market Equilibrium Copyright©2003 Southwestern/Thomson Learning Producer surplus Consumer surplus Price 0 Quantity Equilibrium price Equilibrium quantity Supply Demand A C B D E Those buyers who value the good more than the price (represented by the segment AE on the demand curve) choose to buy the good; those buyers who value it less than the price (represented by the segment EB) do not. Similarly, those sellers whose costs are less than the price (represented by the segment CE on the supply curve) choose to produce and sell the good; those sellers whose costs are greater than the price (represented by the segment ED)

Copyright © 2004 South-Western MARKET EFFICIENCY Three points Concerning Market Outcomes, Free markets allocate 1. the supply of goods to the buyers who value them most highly, as measured by their willingness to pay. 2.The demand for goods to the sellers who can produce them at least cost. 3.Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus. To see why this is true, consider

Figure 8 The Efficiency of the Equilibrium Quantity 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 At quantities less than the equilibrium quantity, the value to buyers exceeds the cost to sellers. At quantities greater than the equilibrium quantity, the cost to sellers exceeds the value to buyers. Therefore, the market equilibrium maximizes the sum of producer and consumer surplus. Consumers, Producers, and the Efficiency of Markets

Copyright © 2004 South-Western MARKET EFFICIENCY 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.

Copyright © 2004 South-Western We can now better appreciate Adam Smith’s invisible hand of the marketplace, The social planner doesn’t need to alter the market outcome because the invisible hand has already guided buyers and sellers to an allocation of the economy’s resources that maximizes total surplus. This conclusion explains why economists often advocate free markets as the best way to organize economic activity.

Copyright © 2004 South-Western 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.

Copyright © 2004 South-Western 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.

Copyright © 2004 South-Western 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.

Copyright © 2004 South-Western 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.

Copyright © 2004 South-Western Assignment Draw the supply and demand for turkey. In the equilibrium, show producer and consumer surplus. Explain why producing more turkey would lower total surplus Explain how buyers’ willingness to pay, consumer surplus, and the demand curve are related. Explain how sellers’ costs, producer surplus, and the supply curve are related. In a supply-and-demand diagram, show producer and consumer surplus in the market equilibrium What is efficiency? Is it the only goal of economic policymakers?

Copyright © 2004 South-Western There are four consumers willing to pay the following amounts for haircuts: Jerry: $7 Oprah: $2 Sally Jessy: $8 Montel: $5 There are four haircutting businesses with the following costs: Firm A: $3 Firm B: $6 Firm C: $4 Firm D: $2 Each firm has the capacity to produce only one haircut. For efficiency, how many haircuts should be given? Which businesses should cut hair, and which consumers should have their hair cut? How large is the maximum possible total surplus?

Copyright © 2004 South-Western Ernie owns a water pump. Because pumping large amounts of water is harder than pumping small amounts, the cost of producing a bottle of water rises as he pumps more. Here is the cost he incurs to produce each bottle of water: Cost of first bottle $1 Cost of second bottle 3 Cost of third bottle 5 Cost of fourth bottle 7 a. From this information, derive Ernie’s supply schedule. Graph his supply curve for bottled water. b. If the price of a bottle of water is $4, how many bottles does Ernie produce and sell? How much producer surplus does Ernie get from these sales? Show Ernie’s producer surplus in your graph. c. If the price rises to $6, how does quantity supplied change? How does Ernie’s producer surplus change? Show these changes in your graph