1. Welfare Economics Consumer Surplus and Producer Surplus

2. 2 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 the equilibrium quantity the right price and the right quantity from society’s point of view? This question takes us into welfare economics.

3. 3 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 in the theory of supply and demand maximizes the total welfare of buyers and sellers

4. 4 Two main concepts When buyers and sellers trade willingly, it must be because they expect to benefit Consumer surplus measures economic welfare of the buyers. Producer surplus measures economic welfare of the sellers.

5. CONSUMER SURPLUS 5

6. 6 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.

7. Willingness to pay: background 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 a good measure of the happiness that he or she gets from it 7

8. Willingness to pay: background Suppose a bag of potato chips provides a fixed amount of happiness If your willingness to pay is –4 bags of potato chips for a shirt, and –2 bags of potato chips for a cup of coffee, then –one can safely say that the shirt makes you twice as happy as the cup of coffee So, your willingness to pay for a commodity is a good measure of how much you like it 8

9. Willingness to pay: background If the dollar price of a bag of potato chips is known, willingness to pay in the example above can also be expressed in dollars 9

10. Willingness to pay: background Another example: –if you are willing to pay $15 for a 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. 10

11. Willingness to pay: background In other words, your willingness to pay for the shirt is –a monetary measure of the happiness you get from the shirt, and –it is proportional to the happiness you get from the shirt, as measured in “haps” 11

12. Table 1 Four Possible Buyers’ Willingness to Pay For a mint-condition recording of Elvis Presley’s first album 12 I will illustrate consumer surplus through this extended example.

13. Consumer Surplus BuyerWillingness to PayConsumer Surplus Buy? John10025Yes Paul805Yes George70-5No Ringo50-25No 13 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…

14. 14 Market Demand The market demand shows the quantities demanded by buyers at different prices. We can use the willingness-to-pay numbers to calculate the market demand –See the next slide

15. 15 The Demand Schedule BuyerWillingness to Pay John100 Paul80 George70 Ringo50

16. Figure 1 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 BuyerWillingness to Pay John100 Paul80 George70 Ringo50 The height of the demand curve at any quantity shows the willingness to pay of whoever bought the last unit. 16

17. 17 Area of a Rectangle Height Width Area = Width × Height

18. Figure 2 Measuring Consumer Surplus with the Demand Curve (a) Price = $80.01 Price of Album 50 70 80 0 $100 Demand 1234 Quantity of Albums John’s willingness to pay ($100) BuyerWillingness to Pay Consumer Surplus Buy? John10020Yes Paul800No George70-10No Ringo50-30No 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. 18

19. 19 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 BuyerWillingness to Pay John100 Paul80 George70 Ringo50

20. Figure 2 Measuring Consumer Surplus with the Demand Curve (b) Price = $70.01 Price of Album 50 70 80 0 $100 Demand 1234 Quantity of Albums BuyerWillingness to Pay Consumer Surplus Buy? John10030Yes Paul8010Yes George700No Ringo50-20No 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. 20

21. 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? 21

22. Interpersonal comparability 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 22

23. 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 Welfare analysis in this course takes utilitarianism as its guiding philosophy 23

24. 24 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, same as in the market outcome we saw before. So, the market does the best that the government could have done Price = $70 BuyerWillingness to Pay John100 Paul80 George70 Ringo50

25. Willingness to Pay from the Demand Curve Quantity Price 0 Demand P1P1 Q1Q1 B A C The area under the demand curve measures the total willingness to pay of the consumers who bought Q 1 units. It also measures the maximum willingness to pay that could be obtained from Q 1 units 25

26. 26 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.

27. How the Price Affects Willingness to Pay Quantity (b) Willingness to Pay at Price P Price 0 Demand A B C DE F P1P1 Q1Q1 P2P2 Q2Q2 Additional willingness to pay from the additional quantity bought at the lower price 27

28. Figure 2 Measuring Consumer Surplus with the Demand Curve (a) Price = $80.01 Price of Album 50 70 80 0 $100 Demand 1234 Quantity of Albums John’s consumer surplus ($20) John’s Payment = $80 John’s Payment ($80) + John’s Consumer Surplus ($20) = John’s Willingness to Pay ($100) John’s willingness to pay ($100) BuyerWillingness to Pay Consumer Surplus Buy? John10020Yes Paul800No George70-10No Ringo50-30No 28

29. Figure 2 Measuring Consumer Surplus with the Demand Curve (b) Price = $70.01 Price of Album 50 70 80 0 $100 Demand 1234 Total consumer surplus ($40) Quantity of Albums John’s consumer surplus ($30) Paul’s consumer surplus ($10) BuyerWillingness to Pay Consumer Surplus Buy? John10030Yes Paul8010Yes George700No Ringo50-20No 29

30. 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 Total Payment Consumer Surplus (ABC) + Total Payment (OBCQ 1 ) = Willingness to Pay (OACQ 1 ) 30

31. 31 Using the Demand Curve to Measure Consumer Surplus In general, the area below the demand curve and above the price measures the consumer surplus.

32. 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 32

33. Shifts in Demand We know that the demand curve can shift, for reasons such as –a change in tastes, and –a change in the prices of related goods 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? 33

34. 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. 34

35. PRODUCER SURPLUS 35

36. 36 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.

37. 37 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.

38. Table 2 The Cost of Painting a House for Four Possible Sellers 38

39. Costs → Supply The supply of house painting services shows the quantity of house painting services supplied at all possible prices The cost numbers in the previous slide can be used to calculate supply of house painting services 39

40. 40 Costs → Supply SellerCost ($) Mary900 Frida800 Georgia600 Grandma500

41. Figure 4 The Supply Schedule and the Supply Curve SellerCost ($) Mary900 Frida800 Georgia600 Grandma500 The height of the supply curve at any quantity shows the production cost to whoever produces the last unit. 41

42. 42 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 $700 we get the following table. SellerCost ($)Producer Surplus Sell? Mary900-200No Frida800-100No Georgia600100Yes Grandma500200Yes

43. 43 Using the Supply Curve to Measure Producer Surplus The area below the price and above the supply curve measures the producer surplus.

44. Figure 5 Measuring Producer Surplus with the Supply Curve Quantity of Houses Painted Price of House Painting 500 800 $900 0 600 1234 (a) Price = $599.99 Supply Grandma’s Cost ($500) SellerCost ($)Producer Surplus Sell? Mary900-300No Frida800-200No Georgia6000No Grandma500100Yes 1. The area under the supply curve is the cost of the quantity supplied 2. It is also the lowest cost for that quantity 44

45. Figure 5 Measuring Producer Surplus with the Supply Curve Quantity of Houses Painted Price of House Painting 500 800 $900 0 600 1234 (a) Price = $599.99 Supply Grandma’s producer surplus ($100) Grandma’s Cost ($500) Total Revenue ($600) = Grandma’s Cost + Grandma’s Producer Surplus Grandma’s Total Revenue $600 1. The rectangular area under the price and up to the quantity supplied is the Total Revenue. 2. The area under the price and above the supply is the Producer Surplus. 45

46. Figure 5 Measuring Producer Surplus with the Supply Curve Quantity of Houses Painted Price of House Painting 500 800 $900 0 600 1234 (a) Price = $599.99 Supply Grandma’s producer surplus ($100) Grandma’s Cost ($500) Total Revenue ($600) = Grandma’s Cost + Grandma’s Producer Surplus 46

47. 47 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 SellerCost ($) Mary900 Frida800 Georgia600 Grandma500

48. Figure 5 Measuring Producer Surplus with the Supply Curve Quantity of Houses Painted Price of House Painting 500 800 $900 0 600 1234 (b) Price = $799.99 Supply SellerCost ($)Producer Surplus Sell? Mary900-100No Frida8000No Georgia600200Yes Grandma500300Yes Grandma’s cost Georgia’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 48

49. 49 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, as we just saw, that’s exactly what happens in the market outcome. So, the market achieves the best that the government could have achieved SellerCost ($) Mary900 Frida800 Georgia600 Grandma500

50. SellerCost ($)Producer Surplus Sell? Mary900-100No Frida8000No Georgia600200Yes Grandma500300Yes Figure 5 Measuring Producer Surplus with the Supply Curve Quantity of Houses Painted Price of House Painting 500 800 $900 0 600 1234 (b) Price = $800 Georgia’s producer surplus ($200) Total producer surplus ($500) Grandma’s producer surplus ($300) Supply 1. The rectangular area under the price and up to the quantity supplied is the Total Revenue. 2. The area under the price and above the supply is the Producer Surplus. 50

51. 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 Production Cost Total Revenue (OBCQ 1 ) = Production Cost (OACQ 1 ) + Producer Surplus (ABC) 51

52. 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 52

53. 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 53