Producers, 7
Consumers, and Consumers, the Efficiency of Markets the
PRINCIPLES OF
MICROECONOMICS
FOURTH CANADIAN EDITION
N. G R E G O R Y M A N K I W R O N A L D D. K N E E B O N E K E N N E T H J. M c K ENZIE NICHOLAS ROWE
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In this chapter, look for the answers to these questions:
What is consumer surplus? How is it related to the
demand curve?
What is producer surplus? How is it related to the supply
curve?
Do markets produce a desirable allocation of resources?
Or could the market outcome be improved upon?
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WelfareEconomics
Recall, the allocation of resources refers to:
how much of each good is produced which producers produce it which consumers consume it
Welfare economics:
the study of how the allocation of resources affects economic well-being
First, we look at the well-being of consumers.
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WillingnesstoPay(WTP)
A buyers willingness to pay for a good is the maximum amount the buyer will pay for that good. WTP measures how much the buyer values the good.
name Anthony Chad Flea John
WTP $250 175 300 125
Example: 4 buyers WTP for an iPod
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WTPandtheDemandCurve
Q: If price of iPod is $200, who will buy an iPod, and what is quantity demanded? A: Anthony & Flea will buy an iPod, Chad & John will not. name Anthony Chad Flea John WTP $250 175 300 125
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Hence, Qd = 2 when P = $200.
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WTPandtheDemandCurve
Derive the demand schedule: P (price of iPod) who buys Qd 0 1 2 3 4
6
$301 & up nobody name Anthony Chad Flea John WTP $250 175 300 125
251 300 Flea
176 250 Anthony, Flea Chad, Anthony, 126 175 Flea John, Chad, 0 125 Anthony, Flea
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WTPandtheDemandCurve
P
$350 $300 $250 $200 $150 $100 $50 $0 0 1 2 3 4
Q
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P $301 & up 251 300 176 250 126 175 0 125
Qd 0 1 2 3 4
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AbouttheStaircaseShape
P
$350 $300 $250 $200 $150 $100 $50 $0
0 1
This D curve looks like a staircase with 4 steps one per buyer. If there were a huge # of buyers, as in a competitive market, there would be a huge # of very tiny steps, and it would look more like a smooth curve. Q
2
3
4
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WTPandtheDemandCurve
P
$350 $300 $250 $200 $150 $100 $50 $0 0 1
Fleas WTP Anthonys WTP Chads WTP Johns WTP
At any Q, the height of the D curve is the WTP of the marginal buyer, the buyer who would leave the market if P were any higher.
Q
2
3
4
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ConsumerSurplus(CS)
Consumer surplus is the amount a buyer is willing to pay minus the buyer actually pays: CS = WTP P name Anthony Chad Flea John WTP $250 175 300 125
Suppose P = $260. Fleas CS = $300 260 = $40. The others get no CS because they do not buy an iPod at this price. Total CS = $40.
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CSandtheDemandCurve
P
$350 $300 $250 $200 $150 $100 $50 $0 0 1
Fleas WTP
P = $260 Fleas CS = $300 260 = $40 Total CS = $40
Q
2
3
4
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CSandtheDemandCurve
P
$350 $300 $250 $200 $150 $100 $50 $0 0 1
Fleas WTP Anthonys WTP
Instead, suppose P = $220 Fleas CS = $300 220 = $80 Anthonys CS = $250 220 = $30 Total CS = $110
Q
2
3
4
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CSandtheDemandCurve
P
$350 $300 $250 $200 $150 $100 $50 $0 0 1 2 3 4
The lesson: Total CS equals the area under the demand curve above the price, from 0 to Q.
Q
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CSwithLotsofBuyers&aSmoothDCurve
Price per pair At Q = 5 (thousand), the marginal buyer is willing to pay $50 for pair of shoes. Suppose P = $30. Then his consumer surplus = $20. P The demand for shoes
$ 60
50 40 30 20 10 0 0
1000s of pairs of shoes D Q
5 10 15 20 25 30
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CSwithLotsofBuyers&aSmoothDCurve
CS is the area b/w P P and the D curve, from $ 60 0 t o Q. Recall: area of a triangle equals x base x height Height of this triangle is $60 30 = $30. So, CS = x 15 x $30 = $225. The demand for shoes
50 h 40 30 20 10 0 0
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D
Q
5 10 15 20 25 30
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HowaHigherPriceReducesCS
If P rises to $40, CS = x 10 x $20 = $100. Two reasons for the fall in CS. P
60 50 40 30
1. Fall in CS due to buyers leaving market
2. Fall in CS due to remaining buyers paying higher P
20 10 0 0
D
Q
5 10 15 20 25 30
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ACTIVELEARNING1:
Consumersurplus
A. Find marginal buyers 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
P 50 $ 45 40 35 30 25 20 15 10 5 0
demand curve
0
5
10
15
20
Q 25
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ACTIVELEARNING1:
Answers
P 50 $ 45 A. At Q = 10, marginal buyers WTP is $30. 40 35 B. CS = x 10 x $10 = $50 30 25 P falls to $20. 20 C. CS for the 15 additional buyers 10 = x 10 x $10 = $50 5 D. Increase in CS 0 on initial 10 units = 10 x $10 = $100
demand curve
0
5
10
15
20
Q 25
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CostandtheSupplyCurve
Cost is the value of everything a seller must give up to
produce a good (i.e., opportunity cost).
Includes cost of all resources used to produce good,
including value of the sellers time.
Example: Costs of 3 sellers in the lawn-cutting business.
name Angelo Hunter Kitty cost $10 20 35 A seller will only produce and sell the good if the price exceeds his or her cost. Hence, cost is a measure of willingness to sell.
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CostandtheSupplyCurve
P $0 9 10 19 name Angelo Hunter Kitty cost $10 20 35
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Derive the supply schedule from the cost data:
Qs 0 1 2 3
20 34 35 & up
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CostandtheSupplyCurve
P
$40 $30 $20 $10 $0 0 1 2 3
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P $0 9 10 19 20 34 35 & up Q
Qs 0 1 2 3
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CostandtheSupplyCurve
P
$40 $30 $20 $10 $0 0 1 2 3
Kittys cost Hunters cost Angelos cost Q
At each Q, the height of the S curve is the cost of the marginal seller, the seller who would leave the market if the price were any lower.
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ProducerSurplus
P
$40 $30 $20 $10 $0 0 1 2 3
Q
PS = P cost Producer surplus (PS): the amount a seller is paid for a good minus the sellers cost.
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ProducerSurplusandtheSCurve
P PS = P cost Kittys cost Hunters cost Angelos cost Q Suppose P = $25. Angelos PS = $15 Hunters PS = $5 Kittys PS = $0 Total PS = $20
$40 $30 $20 $10 $0 0 1 2 3
Total PS equals the area above the supply curve under the price, from 0 to Q.
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PSwithLotsofSellers&aSmoothSCurve
Price per pair Suppose P = $40. At Q = 15(thousand), the marginal sellers cost is $30, and her producer surplus is $10. P The supply of shoes
60 50 40 30 20 10 0 0 5 10 15 20 25 30
25
S
1000s of pairs of shoes
Q
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PSwithLotsofSellers&aSmoothSCurve
PS is the area b/w P and the S curve, from 0 to Q. The height of this triangle is $40 15 = $25. So, PS = x b x h = x 25 x $25 = $312.5 P The supply of shoes
60 50 40 30 h 20 10 0 0 5 10 15 20 25 30
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S
Q
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HowaLowerPriceReducesPS
If P falls to $30, PS = x 15 x $15 = $112.5 Two reasons for the fall in PS. P
60 50 40 30
1. Fall in PS due to sellers leaving market
S
2. Fall in PS due to remaining sellers getting lower P
20 10 0 0 5 10 20 15 25 30
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Q
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ACTIVELEARNING2:
ProducerSurplus
A. Find marginal sellers 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
P 50 45 40 35 30 25 20 15 10 5 0
supply curve
0
5
10
15
20
Q 25
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WhatDoCS,PS,andTotalSurplusMeasure?
CS = (value to buyers) (amount paid by buyers) CS measures the benefit buyers receive from participating in the market. PS = (amount received by sellers) (cost to sellers) PS measures the benefit sellers receive from participating in the market. Total surplus = CS + PS TS measures the total gains from trade in a market.
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TheMarketsAllocationofResources
In a market economy, the allocation of resources
is decentralized, determined by the interactions of many self-interested buyers and sellers.
Is the markets allocation of resources desirable? Or
would a different allocation of resources make society better off?
To answer this, we use total surplus as a measure of
societys well-being.
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MeasuringSocietysWellBeing
Total surplus = CS + PS = (value to buyers) (amount paid by buyers) + (amount received by sellers) (cost to sellers) = (value to buyers) (cost to sellers)
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MarketEfficiency
Total surplus = (value to buyers) (cost to sellers) An allocation of resources is efficient if it maximizes total surplus. Efficiency means:
Raising or lowering the quantity of a good would not increase total surplus. The goods are being produced by the producers with lowest cost. The goods are being consumed by the buyers who value them most highly.
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MarketEfficiency
Total surplus = (value to buyers) (cost to sellers)
Efficiency means making the pie as big as possible. In contrast, equity refers to whether the pie is divided
fairly.
Whats fair is subjective, harder to evaluate. Hence, we focus on efficiency as the goal,
even though policymakers in the real world usually care about equity, too.
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EvaluatingtheMarketEquilibrium
Market eqm: P = $30 Q = 15,000 Total surplus = CS + PS Is the market eqm efficient? P
60 50 40 30 20 10 0 0
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S
CS PS
D
Q
5 10 15 20 25 30
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WhichBuyersGettoConsumetheGood?
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. P
60 50 40 30 20 10 0 0
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S
D
Q
5 10 15 20 25 30
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WhichSellersProducetheGood?
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. P
60 50 40 30 20 10 0 0
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S
D
Q
5 10 15 20 25 30
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DoesEqmQMaximizeTotalSurplus?
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. P
60 50 40 30 20 10 0 0
D S
Q
5 10 15 20 25 30
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DoesEqmQMaximizeTotalSurplus?
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. P
60 50 40 30 20 10 0 0
D S
Q
5 10 15 20 25 30
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EvaluatingtheMarketEqm:Summary
Is the free market equilibrium allocation of resources efficient? Does it maximize total surplus?
The eqm Q maximizes total surplus; The goods are produced by the producers with lowest cost; and The goods are consumed by the buyers who value them most highly.
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EvaluatingtheMarketEqm:Summary
These observations lead to three insights about market outcomes:
1. Free markets allocate the supply of goods to the buyers
who value them most highly, as measured by their willingness to pay; sellers who can produce them at least cost; and
2. Free markets allocate the demand of goods to the 3. Free markets produce the quantity of goods that
maximizes the sum of consumer and producer surplus.
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EvaluatingtheMarketEqm:Summary
Therefore, economic well-being cannot be increased by changing the allocation of consumption among buyers or the allocation of production among sellers. The equilibrium of supply and demand maximizes the sum of consumer and producer surplus. It generates an efficient allocation of resources. The govt cannot improve on the market outcome. Laissez faire (French for allow them to do): the govt should not interfere with the market
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WhyNonMarketAllocationsAreUsuallyBad
Suppose the allocation of resources were instead
determined by a central planner (e.g., the Communist leaders of the former Soviet Union.)
To choose an efficient allocation, the planner would need
to know every sellers cost and every buyers WTP, for each of the thousands of goods produced in the economy.
This is practically impossible, so centrally planned
economies are never very efficient.
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CONCLUSION
This chapter used welfare economics to demonstrate one
of the Ten Principles: Markets are usually a good way to organize economic activity.
But we assumed markets are perfectly competitive. In the real world, sometimes there are
market failures, when unregulated markets fail to allocate resources efficiently. Causes: market power a single buyer or seller can influence the market price, e.g. monopoly externalities side effects of transactions, e.g. pollution
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CONCLUSION
When markets fail, public policy may remedy the
problem and increase efficiency.
Welfare economics sheds light on market failures and
govt policies.
Despite the possibility of market failure,
the assumptions in this chapter work well in many markets, and the invisible hand remains extremely important.
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CHAPTER SUMMARY
The height of the D curve reflects the value of the good
to buyerstheir willingness to pay for it.
Consumer surplus is the difference between what buyers
are willing to pay for a good and what they actually pay.
On the graph, consumer surplus is the area between P
and the D curve.
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CHAPTER SUMMARY
The height of the S curve is sellers cost of producing the
good. Sellers are willing to sell if the price they get is at least as high as their cost.
Producer surplus is the difference between what sellers
receive for a good and their cost of producing it.
On the graph, producer surplus is the area between P
and the S curve.
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CHAPTER SUMMARY
To measure of societys well-being, we use
total surplus, the sum of consumer and producer surplus.
Efficiency means that total surplus is maximized, that the
goods are produced by sellers with lowest cost, and that they are consumed by buyers who most value them.
Under perfect competition, the market outcome is
efficient. Altering it would reduce total surplus.
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End: Chapter 7
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