Ch 7: Consumers, Producers, and the Efficiency of MarketsMonday, October 6, 20146:02 PM -So far, our analysis of prices in the market have been positive (what is) rather than normative (what should be)-Welfare economics: the study of how the allocation of resources affects economic well-beingoThe equilibrium of supply and demand in a market maximizes the total benefits received by buyers and sellers.Consumer Surplus-Willingness to pay: the maximum amount that a buyer will pay for a goodoAt a price equal to his willingness to pay, the buyer would be indifferent about buying the good: If the price is exactly the same as the value he places on the album, he would be equally happy buying it or keeping his money. oConsumer surplus: the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it-Consumer surplus measures the benefit buyers receive from participating in a market. Buyer Willingness to PayJohn $100Paul $80George $70Ringo $50-If John is willing to pay $100 for a record at an auction and only ends up paying $80 for it, he receives a $20 benefit from participating in the auction. -If there are two identical records being sold and John is still willing to pay $100 and another buyer, Paul, isonly willing to pay $80 and the next highest bidder stops at $70 (or slightly higher), then John's consumer surplus is $30 and Paul's consumer surplus is $10. The total consumer surplus in the market is $40-Consumer surplus is closely related to the demand curve for a product.-At any quantity, the price given by the demand curve shows the willingness to pay of the marginal buyer, the buyer who would leave the market first if the price were any higher. -Demand schedule:Price Buyers Quantity DemandedMore than $100 None 0$80 to $100 John 1$70 to $80 John, Paul 2$50 to $70 John, Paul, George 3$50 or less John, Paul, George, and Ringo 4Price of AlbumPrice of AlbumJohn's Consumer Surplus ($20) when the price is $80100John's Willingness to Pay10080Paul's Willingness to Pay80George's Willingness to Pay7070 50Ringo's willingness to pay50"I |"I |12341234Quantity of AlbumsQuantity of Albums Price of Album100John's Consumer Surplus ($30) when the price is $7080Paul's Consumer Surplus ($10) when the price is $70-- - -•IE_70Total ConsumerSurplus ($40)50"I |Quantity of Albums1234-The area below the demand curve and above the price measures the consumer surplus in a market. -An increase in consumer surplus occurs in part because existing customers now pay less and in part because new customers enter the market at the lower price. -What does Consumer Surplus measure?oIt measures the benefit that buyers receive from a good as the buyers themselves perceive it. oThus, consumer surplus is a good measure of economic well-being if policymakers want to respect the preferences of buyers. oIn most markets, consumer surplus DOES reflect economic well-being Producer Surplus-Cost: the value of everything a seller must give up to produce a good-Producer Surplus: the amount a seller is paid for a good minus the seller's cost of providing itSeller CostMary $900Frida $800Georgia $600Grandma $500*When you take bids from the painters, the price might start high, but it quickly falls as the painters compete for the job. Once Grandma has bid $600 (or slightly less), she is the sole remaining bidder. Grandma is happy to do the job for this price because her cost is only $500. The job goes to the painter who can do the work at the lowest cost. Because Grandma is willing to do the work for $500 but gets $600, we say she receives a producer surplus of $100Price of House Painting900Mary's Cost800 600Frida's CostGeorgia's Cost500Grandma'sCost • | | |Quantity of Houses Painted1234 Price of House Painting900800600When the price = $600 - - - -Grandma's Producer Surplus ($100) 500 • | | |Quantity of Houses Painted1234Price of House PaintingTotal Producer Surplus ($500)900800 600_ - - T - _ -When the price = $800t!Georgia's Producer Surplus ($200)Grandma's Producer Surplus ($300)500 • | | |Quantity of Houses Painted1234-Producer surplus is the area below the price and above the supply curve (area ABC). -An increase in producer surplus occurs in part because existing producers now receive more (area BCED) andin part because new producers enter the market at the higher price (area CEF). Additional producer surplus to initial producersD.iQ,¥[Producer Surplus to new producersP, - Producer Surplus!Initial Producer SurplusititQ,Producer Surplus at Price P1Producer Surplus at Price P2Market EfficiencyIs the allocation of resources determined by free markets desirable?-The Benevolent Social Planner wants to maximize the economic well-being of everyone in society. To do this, we measure the economic well-being of society. oTotal Surplus: sum of consumer and producer surplusoTotal Surplus = (Value to buyers - Amount Paid by buyers) + (Amount received by sellers - Cost to sellers)oSince the amount paid by buyers is equal to the amount received by sellers, the total surplus is..oTotal Surplus = Value to buyers - Cost to sellersoEfficiency: The property of a resource allocation of maximizing the total surplus received by all members of society oEquality: the property of distributing economic prosperity uniformly among the members of society-Evaluating the Market EquilibriumoFree markets allocate the supply of goods to they buyers who value them most highly, asmeasured by there willingness to pay. oFree markets allocate the demand for goods to the sellers who can produce them at the lowest cost. oFree markets produce the quantity of goods that maximizes the sum of consumer and producer surplus. -The social planner CANNOT raise total economic well-being by increasing or decreasing the quantity of the good. ConsumerSurplus•ProducerSurplus-Because the market outcome at the equilibrium point makes the sum of consumer and producer surplus as large as it can be, it is an efficient allocation of resources. -The social planner can leave the market just as he finds it. This policy of leaving well enough alone goes by the expression laissez faire-This is based on two assumptions:oOur analysis assumed that markets are perfectly competitive-In some markets, a single buyer or seller may be able to control market prices. The ability to influence prices is called market power. This can cause markets to be inefficient, drawing the price and quantity away from the equilibrium of supply and demandoOur analysis