SUPPLY AND DEMAND

7
Consumers, Producers, and the Efficiency of Markets

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 can be addressed by welfare economics.

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.

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.

Welfare Economics
Consumer surplus measures economic welfare from the buyer’s side.
Producer surplus measures economic welfare from the seller’s side.

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.

CONSUMER SURPLUS
Consumer surplus is the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it.

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.

The Demand Schedule and the Demand Curve

Figure 1 The Demand Schedule and the Demand Curve
Copyright©2003 Southwestern/Thomson Learning
Price of
Album
0
Quantity of
Albums
1
2
3
4

Figure 2 Measuring Consumer Surplus with the Demand Curve
Copyright©2003 Southwestern/Thomson Learning
(a) Price = $80
Price of
Album
50
70
80
0
$100
1
2
3
4
Quantity of
Albums

Figure 2 Measuring Consumer Surplus with the Demand Curve
Copyright©2003 Southwestern/Thomson Learning
(b) Price = $70
Price of
Album
50
70
80
0
$100
1
2
3
4
Quantity of
Albums

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
Quantity
(a) Consumer Surplus at Price
P
Price
0

Figure 3 How the Price Affects Consumer Surplus
Copyright©2003 Southwestern/Thomson Learning
Quantity
(b) Consumer Surplus at Price
P
Price
0

What Does Consumer Surplus Measure?
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.

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.

The Supply Schedule and the Supply Curve

Figure 4 The Supply Schedule and the Supply Curve

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.

Figure 5 Measuring Producer Surplus with the Supply Curve
Copyright©2003 Southwestern/Thomson Learning
Quantity of
Houses Painted
Price of
House
Painting
500
800
$900
0
600
1
2
3
4
(a) Price = $600

Figure 5 Measuring Producer Surplus with the Supply Curve
Copyright©2003 Southwestern/Thomson Learning
Quantity of
Houses Painted
Price of
House
Painting
500
800
$900
0
600
1
2
3
4
(b) Price = $800

Figure 6 How the Price Affects Producer Surplus
Copyright©2003 Southwestern/Thomson Learning
Quantity
(a) Producer Surplus at Price
P
Price
0

Figure 6 How the Price Affects Producer Surplus
Copyright©2003 Southwestern/Thomson Learning
Quantity
(b) Producer Surplus at Price
P
Price
0
P1
B
C
Supply
A
Initial
producer
surplus
Q1

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?

MARKET EFFICIENCY
Consumer Surplus
= Value to buyers – Amount paid by buyers
and
Producer Surplus
= Amount received by sellers – Cost to sellers

MARKET EFFICIENCY
Total surplus
= Consumer surplus + Producer surplus
or
Total surplus
= Value to buyers – Cost to sellers

MARKET EFFICIENCY
Efficiency is the property of a resource allocation of maximizing the total surplus received by all members of society.

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.

Figure 7 Consumer and Producer Surplus in the Market Equilibrium
Copyright©2003 Southwestern/Thomson Learning
Price
0
Quantity

MARKET EFFICIENCY
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.

Figure 8 The Efficiency of the Equilibrium Quantity
Copyright©2003 Southwestern/Thomson Learning
Quantity
Price
0

Evaluating the Market Equilibrium
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.

Evaluating the Market Equilibrium
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.

Evaluating the Market Equilibrium
Externalities
created when a market outcome affects individuals other than buyers and sellers in that market.
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.

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.

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.

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.