Consumers,
Producers,and the
Efficiency of Markets
Chapter 7
Copyright ? 2001 by Harcourt,Inc.
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Revisiting the Market
Equilibrium
Do the equilibrium price and
quantity maximize the total
welfare of buyers and sellers?
?Market equilibrium reflects the way
markets allocate scarce resources.
? Whether the market allocation is
desirable is determined by welfare
economics.
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Welfare Economics
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,
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Welfare Economics
Equilibrium in the market results in
maximum benefits,and therefore
maximum total welfare for both the
consumers and the producers of the
product.
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Welfare Economics
?Consumer surplus measures economic
welfare from the buyer’s side.
?Producer surplus measures economic
welfare from the seller’s side.
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Consumer Surplus
?Willingness to pay is the maximum
price that a buyer is willing and able
to pay for a good.
?It measures how much the buyer
values the good or service.
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Consumer Surplus
Consumer surplus is the amount
a buyer is willing to pay for a
good minus the amount the buyer
actually pays for it.
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Four Possible Buyers’ Willingness
to Pay...
B u y er W i l l i n g n ess to Pay
J ohn $100
Paul 80
George 70
R ingo 50
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Consumer Surplus
The market demand curve depicts
the various quantities that buyers
would be willing and able to
purchase at different prices.
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Four Possible Buyers’ Willingness
to Pay...
Pri ce B u y er
Qu an ti ty
D ema n d ed
M ore th an $ 100 None 0
$80 to $ 100 John 1
$70 to $ 80 Joh n,P aul 2
$50 to $ 70 Joh n,P aul,Ge orge 3
$50 or le ss Ringo 4
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Measuring Consumer Surplus with
the Demand Curve...
Price of
Album
50
70
80
0
$100
1 2 3 4 Quantity ofAlbums
John’s willingness to pay
Paul’s willingness to pay
George’s willingness to pay
Ringo’s willingness to pay
Demand
Harcourt,Inc,items and derived items copyright ? 2001 by Harcourt,Inc.
Measuring Consumer Surplus with
the Demand Curve...
Price of
Album
50
70
80
0
$100
1 2 3 4 Quantity ofAlbums
Demand
John’s consumer surplus ($20)
Price = $80
Harcourt,Inc,items and derived items copyright ? 2001 by Harcourt,Inc.
Measuring Consumer Surplus with
the Demand Curve...
Price of
Album
50
70
80
0
$100
1 2 3 4 Quantity ofAlbums
Demand
John’s consumer surplus ($30)
Total
consumer
surplus ($40)
Price = $70
Paul’s consumer surplus ($10)
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Measuring Consumer Surplus with
the Demand Curve
The area below the demand curve
and above the price measures the
consumer surplus in the market.
Q2
P2
How the Price Affects Consumer
Surplus...
Quantity
Price
0
Demand
Copyright ? 2001 by Harcourt,Inc,All rights reserved
Initial
consumer
surplus
Additional
consumer
surplus to
initial
consumers
Consumer
surplus to new
consumers
Q1
P1
D E F
B C
A
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Consumer Surplus and Economic
Well-Being
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.
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Producer Surplus
?Producer surplus is the amount a
seller is paid minus the cost of
production,
?It measures the benefit to sellers
participating in a market.
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The Costs of Four Possible
Sellers...
Sell er C o st
M ary $900
F rida 800
Georgia 600
Grandm a 500
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Producer Surplus and the
Supply Curve
?Just as consumer surplus is related to the
demand curve,producer surplus is
closely related to the supply curve.
?At any quantity,the price given by the
supply curve shows the cost of the
marginal seller,the seller who would
leave the market first if the price were
any lower.
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Supply Schedule for the Four
Possible Sellers...
Price Se ll ers
Q u an tity
Su p p li ed
$ 9 0 0 o r m o re M a ry,F ri d a,Ge o rg i a,
Gr a n d ma
4
$ 8 0 0 to $ 9 0 0 F ri d a,Ge o rg i a,Gr a n d ma 3
$ 6 0 0 to $ 8 0 0 Ge o rg i a,Gr a n d ma 2
$ 5 0 0 to $ 6 0 0 Gr a n d ma 1
L e ss th a n $ 5 0 0 N o n e 0
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Producer Surplus and the
Supply Curve...
Quantity of
Houses Painted
Price of
House
Painting
500
800
$900
0
600
1 2 3 4
Grandma’s cost
Georgia’s cost
Frida’s cost
Mary’s cost
Supply
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The area below the price and above
the supply curve measures the
producer surplus in a market.
Producer Surplus and the
Supply Curve
Harcourt,Inc,items and derived items copyright ? 2001 by Harcourt,Inc.
Measuring Producer Surplus with the
Supply Curve...
Quantity of
Houses Painted
Price of
House
Painting
500
800
$900
0
600
1 2 3 4
Supply
Grandma’s producer
surplus ($100)
Price = $600
Harcourt,Inc,items and derived items copyright ? 2001 by Harcourt,Inc.
Measuring Producer Surplus with the
Supply Curve...
Quantity of
Houses Painted
Price of
House
Painting
500
800
$900
0
600
1 2 3 4
Supply
Grandma’s producer
surplus ($300)
Price = $800
Georgia’s producer
surplus ($200)
Total
producer
surplus ($500)
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P2
Q2
How Price Affects Producer
Surplus...
Quantity
Price
0
Supply
Q1
P1
A
B
CInitial
Producer
surplus
Additional producer
surplus to initial
producers
D E F
Producer surplus
to new producers
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Market Efficiency
Consumer surplus and producer
surplus may be used to address the
following question:
Is the allocation of resources
determined by free markets in any way
desirable?
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Economic Well-Being and Total
Surplus
and
Consumer
Surplus =
Value to
buyers
_ Amount paid
by buyers
Producer
Surplus =
Amount received
by sellers
_ Cost to
sellers
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Economic Well-Being and Total
Surplus
or
Total
Surplus =
Value to
buyers _
Cost to
sellers
Total
Surplus =
Consumer
Surplus
Producer
Surplus+
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Market Efficiency
Market efficiency is achieved when
the allocation of resources
maximizes total surplus.
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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.
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Evaluating the Market Equilibrium...
Price
Equilibrium
price
0 QuantityEquilibrium
quantity
A
Supply
C
B Demand
D
E
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Consumer and Producer Surplus in
the Market Equilibrium...
Price
Equilibrium
price
0 QuantityEquilibrium
quantity
A
Supply
C
B Demand
D
E
Producer
surplus
Consumer
surplus
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Three Insights Concerning
Market Outcomes
?Free markets allocate the supply of goods to
the buyers who value them most highly.
?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.
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Price
0 QuantityEquilibrium
quantity
Supply
Demand
Cost
to
sellers
Value
to
buyers
Value
to
buyers
Cost
to
sellers
Value to buyers is greater
than cost to sellers.
Value to buyers is less
than cost to sellers.
The Efficiency of the Equilibrium
Quantity
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The Efficiency of the
Equilibrium Quantity
?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.
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Market Power
?If a market system is not perfectly
competitive,market power may result.
?Market power is the ability to influence
prices.
?Market power can cause markets to be
inefficient because it keeps price and
quantity from the equilibrium of supply
and demand.
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Externalities
Externalities are created when a market
outcome affects individuals other than
buyers and sellers in that market.
?Externalities cause welfare in a market to
depend on more than just the value to the buyers
and cost to the sellers.
?When buyers and sellers do not take externalities
into account when deciding how much to consume
and produce,the equilibrium in the market can be
inefficient.
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Summary
?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.
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Summary
?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.
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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.
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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.
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Graphical
Review
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Measuring Consumer Surplus with
the Demand Curve...
Price of
Album
50
70
80
0
$100
1 2 3 4 Quantity ofAlbums
John’s willingness to pay
Paul’s willingness to pay
George’s willingness to pay
Ringo’s willingness to pay
Demand
Harcourt,Inc,items and derived items copyright ? 2001 by Harcourt,Inc.
Measuring Consumer Surplus with
the Demand Curve...
Price of
Album
50
70
80
0
$100
1 2 3 4 Quantity ofAlbums
Demand
John’s consumer surplus ($20)
Price = $80
Harcourt,Inc,items and derived items copyright ? 2001 by Harcourt,Inc.
Measuring Consumer Surplus with
the Demand Curve...
Price of
Album
50
70
80
0
$100
1 2 3 4 Quantity ofAlbums
Demand
John’s consumer surplus ($30)
Total
consumer
surplus ($40)
Price = $70
Paul’s consumer surplus ($10)
How the Price Affects Consumer
Surplus...
Q2
P2
Quantity
Price
0
Demand
Copyright ? 2001 by Harcourt,Inc,All rights reserved
Initial
consumer
surplus
Additional
consumer
surplus to
initial
consumers
Consumer
surplus to new
consumers
Q1
P1 B C
A
D E F
Harcourt,Inc,items and derived items copyright ? 2001 by Harcourt,Inc.
Producer Surplus and the
Supply Curve...
Quantity of
Houses Painted
Price of
House
Painting
500
800
$900
0
600
1 2 3 4
Grandma’s cost
Georgia’s cost
Frida’s cost
Mary’s cost
Supply
Harcourt,Inc,items and derived items copyright ? 2001 by Harcourt,Inc.
Measuring Producer Surplus with the
Supply Curve...
Quantity of
Houses Painted
Price of
House
Painting
500
800
$900
0
600
1 2 3 4
Supply
Grandma’s producer
surplus ($100)
Price = $600
Harcourt,Inc,items and derived items copyright ? 2001 by Harcourt,Inc.
Measuring Producer Surplus with the
Supply Curve...
Quantity of
Houses Painted
Price of
House
Painting
500
800
$900
0
600
1 2 3 4
Supply
Grandma’s producer
surplus ($300)
Price = $800
Georgia’s producer
surplus ($200)
Total
producer
surplus ($500)
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How Price Affects Producer
Surplus...
P2
Q2 Quantity
Price
0
Supply
Q1
P1
A
B
CInitial
Producer
surplus
Additional producer
surplus to initial
producers
D E F
Producer surplus
to new producers
Harcourt,Inc,items and derived items copyright ? 2001 by Harcourt,Inc.
Evaluating the Market Equilibrium...
Price
Equilibrium
price
0 QuantityEquilibrium
quantity
A
Supply
C
B Demand
D
E
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Consumer and Producer Surplus in
the Market Equilibrium...
Price
Equilibrium
price
0 QuantityEquilibrium
quantity
A
Supply
C
B Demand
D
E
Producer
surplus
Consumer
surplus
Harcourt,Inc,items and derived items copyright ? 2001 by Harcourt,Inc.
Price
0 QuantityEquilibrium
quantity
Supply
Demand
Cost
to
sellers
Value
to
buyers
Value
to
buyers
Cost
to
sellers
Value to buyers is greater
than cost to sellers.
Value to buyers is less
than cost to sellers.
The Efficiency of the Equilibrium
Quantity