Overview

1
Overview

• Welfare Economics
• Consumer Surplus
• Producer Surplus
• Market Efficiency

2
Market Equilibrium Revisited Does the
equilibrium price and quantity result in the
maximum total welfare of buyer and seller?
QE
3
Market Equilibrium RevisitedDoes the equilibrium
price and quantity result in the maximum total
welfare of buyer and seller?

• Market equilibrium illustrates the way markets
  allocate scarce resources.
• But does it answer whether that market
  allocation is desirable?
• Turn to Welfare Economics to answer the question.

4
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 makes the sum of
  these benefits as large as possible.

5
Welfare Economics

• Equilibrium in the market results in maximum
  benefits, and therefore total welfare for both
  the buyer and the seller.
• Welfare Economics from the Buyer Side and the
  Seller Side
• Consumer Surplus
• Producer Surplus

6
Welfare Economics Consumer Surplus

• Market Demand Curve depicts the various
  quantities that buyers would want to purchase at
  different prices.
• What determines how much a consumer would be
  willing to pay (the maximum price) for a good or
  service?
• Answer The expected benefits received or
  Utility.

7
Marginal Utility (MU) is...

• the amount of utility (satisfaction) that one
  more or one less unit of consumption adds to or
  subtracts from total utility.
• Consumers try to obtain the largest possible
  total satisfaction (utility) from the mix of
  goods and services they buy with their incomes.

8
Consumer Surplus is...

• the maximum amount a consumer will be willing
  to pay for a good depends upon the expected
  utility (benefits) of that good.
• Willingness to Pay
• The maximum price that a buyer is willing and
  able to pay for a good.
• Measures how much the buyer values the good or
  service.

9
Consumer Surplus Verbal Definition

• The amount a buyer is willing to pay for a good
  minus the amount the buyer actually pays for it.

D
10
Consumer Surplus Graphical
S
Pmax
PE
D
QE
11
Consumer Surplus Graphical
S
Pmax
Consumer Surplus
PE
D
QE
12
Consumer Surplus and Market Price

• The area below the demand curve and above the
  market price measures the consumer surplus in a
  market. Hence,
• A lower market price will increase consumer
  surplus
• A higher market price will reduce consumer surplus

13
Consumer Surplus Mathematically

• Maximum Price 11
• Market Price 6
• Quantity Purchased 6
• Assume Price drops 1 for every additional unit
  sold.
• Consumer Surplus 15
• 51 - 36 15
• (11109876) - (6 x 6) 15

14
11
10
9
8
7
6
Market Price
D
6
5
4
3
2
1
Quantity Purchased
15
11
10
Total Consumer Benefits
9
8
7
6
D
6
5
4
3
2
1
16
11
10
9
8
Consumers Expense
7
6
D
6
5
4
3
2
1
17
Consumer Benefit -Consumer Expense CONSUMER
SURPLUS!
11
10
9
8
51 - 36 15
7
6
D
6
5
4
3
2
1
18
Producer Surplus

• Market Supply Revisited
• Depicts the various quantities that suppliers
  would be willing to sell at different prices.
• May be viewed as a measure of supplier costs,
  i.e.. the opportunity cost to the seller of
  supplying various quantities of the good.

19
Producer Surplus

• Market Supply The marginal opportunity cost of
  production increases as market output expands.
• Because the producers cost is the lowest price
  he/she would accept it may be considered a
  measure of his/her willingness to sell.

20
Producer Surplus Verbal Definition

• The amount a seller is paid minus the cost of
  production.
• Producer surplus measures the benefit to sellers
  of participating in a market.

S
21
Producer Surplus Graphical
S
PE
D
QE
22
Producer Surplus Graphical
S
PE
Producer Surplus
D
QE
23
Producer Surplus Mathematically

• Minimum Price 1
• Market Price 6
• Quantity Sold 6
• Assume Price increases 1 for every additional
  unit sold.
• Producer Surplus 15
• 36 - 21 15
• (6 x 6) - (1 2 3 4 5 6) 15

24
S
6
5
4
3
2
1
6
5
4
3
2
1
25
Total Producer Benefits
S
6
5
4
3
2
1
6
5
4
3
2
1
26
Producer Surplus 15
S
6
5
4
Producer Costs
3
2
1
6
5
4
3
2
1
27
Market Efficiency

• Under the assumptions of perfect competition and
  no externalities, the economic well-being of a
  society is measured as the sum of consumer
  surplus and producer surplus.
• Market Efficiency is attained when total surplus
  is maximized, a point where resource allocation
  is efficient.

28
Market Efficiency
S
PE
D
29
Market Efficiency
S
Consumer Surplus
PE
Producer Surplus
D
30
Market Efficiency Three observations

• 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.

31
Market Efficiency Invisible Hand

• In a free market system the many buyers and
  sellers are interested in their own well-being,
  self-interest.
• As market participants are motivated by
  self-interest a process of coordination and
  communication takes place so that buyers and
  sellers are directed to the most efficient
  outcome.
• As if by an Invisible Hand, the free market
  system reaches efficiency.

32
Market Failure

• If a market system is not one of perfect
  competition, control over prices leads to Market
  Power.
• The ability by one buyer or seller to control
  market price.
• Market Power causes markets to be inefficient,
  and thus fail.

33
Market Failure

• If a market system affects individuals other than
  buyers and sellers of that market, side-effects
  are created and called Externalities.
• Benefits or costs imposed on a third party who is
  not the consumer or the producer.
• Externalities cause markets to be inefficient,
  and thus fail.