Slide 1Welfare EconomicsConsumer SurplusConsumer SurplusConsumer SurplusProducer SurplusProducer SurplusProducer SurplusMarket EfficiencyMarket EfficiencyMarket EfficiencyECON 203: Principles of MicroeconomicsClass 9: Consumer Surplus, Producer Surplus, and Efficiency1Welfare Economics•Welfare economics is the study of how the allocation of resources affects economic well-being.•Objectives.–Measure the benefits of trade to buyers and sellers.•Magnitude.•Distribution between buyers and sellers.•Distribution between different types of buyers and sellers.–Maximize the social benefits of trade. •Market efficiencies.•Market failures.•Effects of economic policies on benefits of trade.2Consumer Surplus•Consumers surplus.–Measures the benefits of trade to buyers.–Calculated as the amount buyers are willing to pay for a good minus the amount the buyers actually pay for it.•Willingness to pay.–Maximum amount that a buyer will pay for a good.3Consumer Surplus•Example: value of buying a smartphone.–Willingness to pay of 6 people given by the following table: –When P = $600 three people are willing to buy, so quantity demanded is 3.–In general, the demand curve represents willingness to pay.4Monica $1,000Chandler $800Rachel $600Joey $400Ross $200Phoebe $0Consumer Surplus•Consumer surplus from buying iPhones.– A person’s benefit of the trade is given by the difference between willingness to pay and price paid in the market.– Consumer surplus in the market is given by the sum of the benefit of trade to each consumer.–In markets with thousands of consumers, consumer surplus can be calculated as the area below the demand curve and above the price.5Producer Surplus•Producer surplus.–Measures the benefits of trade to sellers.–Calculated as the amount sellers are paid for a good minus the price at which they would be willing to sell the good.•Willingness to sell.–Minimum amount the seller requires to sell a good.–Given by the seller’s cost of production. 6Producer Surplus•Example: cost of producing a smartphone.–Willingness to sell of 6 producers given by the following table: –When P = $600 three sellers are willing to sell, so quantity sold is 3.–The supply curve represents the cost of production and willingness to sell.7Apple $400Samsung $500Huawei $600Vivo $700Lenovo $800Blackberry $900Producer Surplus•Producer surplus from selling iPhones.– The benefit of trade for the producer is given by the difference between the price received in the market and the price at which the buyer would be willing to sell.–Producer surplus in the market is given by the sum of the benefit of trade to each producer.–In markets where producers can sell unlimited quantities, producer surplus can be calculated as the area above the supply curve and below the price.8Market Efficiency•Consumer surplus (CS) and Producer Surplus (PS) are used to evaluate the total welfare of buyers and sellers.•Total surplus (the sum of CS and PS) is used to measure social welfare.CS = value to buyers – amount paid by buyersPS = amount received by sellers – cost to sellersTotal Surplus = CS + PS = value to buyers – cost to sellers•An allocation of resources is efficient if it maximizes total surplus.9Market Efficiency•Evaluating market equilibrium.–Example: the market for smartphones.–In market equilibrium:•Goods are allocated to buyers who value them most and produced by sellers with the lowest costs.•Total surplus is maximized leading to efficiency.10Quantity Demand Supply1 million $1,000 $4002 million $800 $5003 million $600 $6004 million $400 $7005 million $200 $8006 million $0 $900Market Efficiency•Some caveats regarding assumptions.– Markets are perfectly competitive.– Market outcomes matter only to buyers and sellers.– In reality, either or both of these may not hold due to market power or externalities.•Market failure: the inability of certain markets to allocate resources