DEFINITION

1
DEFINITION
Welfare Economics is the study of how the
allocation of resources affects economic
well-being.
2
WILLINGNESS TO PAY
Recall that the market demand curve is the
sum of individual demand curves
and it gives the
total quantity that all buyers would
willingly purchase at a given price.
P
Q
3
WILLINGNESS TO PAY
At a higher price a smaller quantity would be
demanded, i.e., willingly purchased.
P
At the higher price some buyers would stop being
willing to pay to buy.
P
Q
Q
4
WILLINGNESS TO PAY
Since the market demand curve is the sum of
individual buyers demand curves, the market
demand curve shows the maximum that some buyer is
willing to pay.
5
WILLINGNESS TO PAY
Therefore each potential buyer has a certain
(maximum) willingness to pay a price for the
good that buyer would not be pay a higher
price.
6
WILLINGNESS TO PAY
Then there is some buyer that is willing to pay
price p1 for the first unit of the good
P1
P2
And some buyer willing to pay p2 for the
second unit of the good
Pn
1
2
n
etc.
7
WILLINGNESS TO PAY

Then area A under the demand curve is the total
amount that buyers would be willing to pay for
100 units of the good.
A
100
8
WILLINGNESS TO PAY

However to buy 100 units of the good in a
competitive market, each buyer only pays the
price P -- even those buyers willing to pay
more.
B
P
C
100
9
WILLINGNESS TO PAY

Buyers are willing to pay the sum of areas B and
C, but only need pay the area C to get 100
units -- they pay less than they are willing to
pay.
B
P
C
100
10
CONSUMER SURPLUS

The amount that buyers are willing to pay minus
the amount that they actually pay is
called consumer surplus. It is the area B,
under the demand curve and above the market price.
CONSUMER SURPLUS
B
P
100
11
CONSUMER SURPLUS

Lowering price from P to P gives buyers a
larger consumer surplus -- area B, plus area
D, plus area E.
B
E
P
D
P
100
125
12
CONSUMER SURPLUS

Area D is the additional consumer surplus gained
by the buyers of the first 100 units as a result
of paying the lower price P. Area E is the
additional consumer surplus gained by the buyers
of the next 25 units.
B
E
P
D
P
100
125
13
CONSUMER SURPLUS
Therefore consumers welfare can be improved when
market price is lowered. However there are
costs of supplying the good, and to
determine whether the benefits to society
outweigh the costs we must also consider the
costs. The supply curve provides information
about the costs to society.
14
WILLINGNESS TO SELL
The market supply curve is the sum of
individual sellers supply curves, and each
seller is only willing to supply the good if the
costs of doing so are covered by the price
received. The seller must not only cover the
cost of materials and labor, but also normally
requires a profit. From the viewpoint of
society this profit is necessary to keep
resources in the production of this good.
15
WILLINGNESS TO SELL
The seller must receive a profit as large as
could be earned in the next best opportunity in
order to continue supplying this good, and not
using labor and material resources in some
other enterprise. Therefore the supply curve
represents the social cost of supply the good.
It includes the opportunity cost in addition to
other direct costs, such as material and labor.
16
WILLINGNESS TO SELL
The supply curve gives the minimum price at
which sellers are willing to supply a good. As
price rises sellers are willing to supply
additional units.
17
WILLINGNESS TO SELL
Suppose sellers are willing to supply Q units at
a price P for each unit. Then they receive a
total revenue P x Q (area A).
P
A
Q
18
WILLINGNESS TO SELL
Sellers would be willing to supply Q units for
the amount in area B, so that they receive a
surplus amount as area C when they sell Q units
at P each.
P
C
B
Q
19
PRODUCER SURPLUS
Producer surplus is the amount the seller is
paid minus the amount the seller would have been
willing to accept. It is the area C, above the
supply curve and below the market price.
PRODUCER SURPLUS
P
C
Q
20
MARKET EQUILIBRIUM
The total surplus is consumer surplus producer
surplus, area A area B.
A
B
21
MARKET EQUILIBRIUM
The total surplus (Value to buyers - PE) (PE -
Cost to sellers) Value to buyers - Cost to
sellers.
A
B
22
MARKET EQUILIBRIUM
Consumer plus producer surplus is the net
benefit to society of producing QE, since the
benefits to buyers are benefits to members
of society and the costs to sellers are social
costs.
A
B
QE
23
SOCIAL WELFARE
Society benefits anytime an individual buyer
values a unit of a good more than the cost of
supplying it, i.e., more than the opportunity
cost of not producing other goods with the
resources used by producing this good. Then
society benefits by producing a unit of the good
when the value to buyers exceeds the cost to
sellers, and loses when the cost to sellers
exceeds the value to buyers.
24
DEFINITION
Economic efficiency occurs when resources are
allocated so that social welfare is maximized.
25
ECONOMIC EFFICIENCY
Q is the socially efficient level of output,
since for output levels below Q, such as QA,
value to buyers exceeds cost to sellers
A
B
QA
QB
26
ECONOMIC EFFICIENCY
while for output greater than Q, such as QB,
cost to sellers exceeds value to buyers.
Therefore producing all units up to Q
increases social welfare,
A
B
QA
QB
27
ECONOMIC EFFICIENCY
while producing any units beyond Q reduces
social welfare. Therefore allocating
resources to produce Q units of output
maximizes social welfare.
A
B
QA
QB
28
EFFICIENCY OF MARKETS
Q is the efficient level of output and it is
also the level of output for a competitive
market in equilibrium. Therefore competitive
markets are economically efficient in maximizing
social welfare.
29
EFFICIENCY OF MARKETS
Note that we need markets to be competitive for
this result to be achieved. Additionally
there should not be any externalities or else
supply will not accurately reflect social costs
of production and consumption.
30
THE INVISIBLE HAND
Adam Smith in the Wealth of Nations (1776) stated
that that individuals, pursuing their own selfish
interests, are led by an invisible hand
to promote the social welfare. The functioning
of a competitive market is the invisible hand.
31
MARKET EQUILIBRIUM
A competitive market equilibrium is efficient,
with buyers benefit equaling consumer surplus
(area A) and sellers benefit equaling producer
surplus (area B).
A
B
32
INTERFERENCE WITH MARKET FORCES
When the market is free of restrictions, the
equilibrium price and quantity will be P and
Q. Consumer surplus will be triangle Pba, and
producer surplus will be triangle Pbc.
a
DEADWEIGHT LOSS
A
P
b
PC
B
c
Q
QC
33
INTERFERENCE WITH MARKET FORCES
Suppose policy makers believe that consumer
surplus is too small and the benefit to sellers
(producer surplus) is too large. As a result
they impose a price ceiling (PC) below the
market price to increase consumer surplus and
lower producer surplus.
a
DEADWEIGHT LOSS
A
P
b
PC
B
c
Q
QC
34
INTERFERENCE WITH MARKET FORCES
The effect of the price ceiling will be to lower
market price to PC and market quantity to QC.
Producer surplus will be reduced to area B, and
consumer surplus will be area A. However the sum
of areas A and B is less than the sum of consumer
and producer
a
DEADWEIGHT LOSS
A
P
b
PC
B
c
Q
QC
35
INTERFERENCE WITH MARKET FORCES
surplus when Q is the market (equilibrium)
quantity. The difference is the triangular area
labeled deadweight loss. This is a loss to
society because resources are not being optimally
allocated. For all units between QC and Q
a
DEADWEIGHT LOSS
A
P
b
PC
B
c
Q
QC
36
INTERFERENCE WITH MARKET FORCES
the benefit of producing those units (as given by
the demand curve) exceeds the (social) cost of
producing them (as given by the supply curve).
Therefore the price ceiling causes an inefficient
allocation of resources. Social welfare will be
larger
a
DEADWEIGHT LOSS
A
P
b
PC
B
c
Q
QC
37
INTERFERENCE WITH MARKET FORCES
if the market is allowed to operate freely,
without the price ceiling. In this case there is
a tradeoff between economic efficiency and
equity. Attempting to make the distribution of
benefits more equitable results in a decrease
in social welfare.
a
DEADWEIGHT LOSS
A
P
b
PC
B
c
Q
QC