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How desirable is market equilibrium?

 Do equilibrium price & quantity maximise buyer &


seller welfare?

 Whether the market allocation is desirable can be


addressed by welfare economics.
Welfare economics
 Welfare economics studies how the allocation of
resources affects economic well-being.

 Buyers and sellers receive benefits from taking part in


markets.

 We show: The equilibrium in a competitive market


maximises the total welfare of buyers & sellers.
Welfare economics
 Consumer surplus measures economic welfare in
dollars from the buyer’s side.

 Producer surplus measures economic welfare in dollars


from the seller’s side.

 Consumer + producer surplus = social surplus.


Consumer surplus
 Willingness to pay (WTP) is the maximum amount a
buyer will pay for a good or service.
 Measures how much the buyer values the good or
service.

 Consumer surplus is the buyer’s WTP for a good minus


the amount the buyer actually pays for it.
Four possible buyers’ WTP

Buyer WTP

John $100

Paul $80

George $70

Ringo $50
The demand schedule
 The market demand depicts the various quantities that
buyers will buy at different prices.
Price Buyers Quantity demanded

More 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, 4


Ringo
The demand curve
Price of
Album

$100 John’s WTP

80 Paul’s WTP
70 George’s WTP

50 Ringo’s WTP

Demand

0 1 2 3 4 Quantity of
Albums
Copyright©2003 Southwestern/Thomson Learning
Measuring consumer surplus
Suppose price = $80

Price of
album

$100
John’s consumer surplus ($20)

80

70

50

Demand

0 1 2 3 4 Quantity of
albums

Copyright©2003 Southwestern/Thomson Learning


Measuring consumer surplus
Suppose price = $70
Price of
album
$100
John’s consumer surplus ($30)

80
Paul’s consumer
70 surplus ($10)

Total
50 consumer
surplus ($40)

Demand

0 1 2 3 4
Quantity of
albums

Copyright©2003 Southwestern/Thomson Learning


Measuring consumer surplus
 The area below the demand curve & above the price
measures the consumer surplus in the market.
Hence:
Consumer Surplus at Price P
Price
A

Consumer
surplus
P1
B C

Demand

0 Q1 Quantity
Copyright©2003 Southwestern/Thomson Learning
If price falls from P1 to P2
Price
A

Initial
consumer
surplus
C Consumer surplus
P1
B to new consumers

F
P2
D E
Additional consumer Demand
surplus to initial
consumers
0 Q1 Q2 Quantity
Copyright©2003 Southwestern/Thomson Learning
What does consumer surplus measure?

 Consumer surplus, measures WTP minus the amount


actually paid…….

 …… the net benefit that buyers receive from a good as


the buyers themselves perceive it.

 Valued in dollars.
Producer surplus
 Producer surplus is the amount a seller is paid for a
good minus the seller’s cost.

 Measures benefit to sellers from participating in a


market.

 Producer surplus closely related to the supply curve.


Costs of four possible sellers
Seller Cost

Agnetha $900

Benny $800

Bjorn $600

Anni-Frid $500

Copyright©2004 South-Western
The supply schedule
Price Sellers Quantity supplied

$900 or more Agnetha, Benny, Bjorn, 4


Anni-Frid
$800 to $900 Benny, Bjorn, Anni-Frid 3

$600 to $800 Bjorn, Anni-Frid 2

$500 to $600 Anni-Frid 1

Less than $500 None 0


The supply curve

Agnetha’s cost

Benny’s cost

Bjorn’s cost
Anni-Frid’s cost
Using supply to measure producer surplus
 The area below the price & above the supply curve
measures the producer surplus.
Measuring producer surplus with the supply curve
Price = $600
Price of
House
Painting Supply

$900
800

600
500
Anni-Frid’s
Grandma’s producer
producer
surplus ($100)
surplus ($100)

0 1 2 3 4
Quantity of
Houses Painted
Copyright©2003 Southwestern/Thomson Learning
Measuring producer surplus with the supply curve
Price = $800
Price of
House
Painting Supply
Total
producer
$900 surplus ($500)

800

600 Bjorn’s producer


500 surplus ($200)

’ producer
Anni-Frid’s
surplus ($300)

0 1 2 3 4
Quantity of
Houses Painted
Copyright©2003 Southwestern/Thomson Learning
With a more general supply curve
Producer surplus at price P1
Price
Supply

B
P1
C
Producer
surplus

0 Q1 Quantity
Copyright©2003 Southwestern/Thomson Learning
If price increases to p2
Producer surplus at price P2
Price
Additional producer Supply
surplus to initial
producers

D E
P2 F

B
P1
Initial C
Producer surplus
producer to new producers
surplus

0 Q1 Q2 Quantity
Copyright©2003 Southwestern/Thomson Learning
Market efficiency
 A resource allocation is Pareto efficient if it is
impossible to make somebody better-off without
making someone else worse off.

 If you can make someone better off without harming


anyone else an allocation is Pareto inefficient.

 We show a market allocation maximises social surplus.


It is therefore Pareto efficient – we say efficient.
Proposition: First Theorem of Welfare Economics

 A free-market equilibrium where supply = demand:

 Is Pareto efficient – maximises the benefits to


consumers plus producers in the sense of maximising
social surplus.

Proof: I’ll give a rough proof shortly - any other non-


equilibrium price provides less social surplus.
Market efficiency-illustration
Price A

D
Supply

Consumer
surplus

Equilibrium E
price
Producer
surplus

Demand
B

0 Equilibrium Quantity
quantity Copyright©2003 Southwestern/Thomson Learning
Market outcomes

 Free markets allocate the supply of goods to buyers


who value them most, as measured by their
willingness to pay.

 Free markets allocate the demand to sellers who can


produce them at least cost.

 Thus free markets maximise social surplus.


Rough proof: other prices provide less surplus
Price
Supply

Value Cost
to to
buyers sellers

Cost Value
to to
sellers buyers Demand

0 Equilibrium Quantity
quantity

Value to buyers is greater Value to buyers is less


than cost to sellers. than cost to sellers.

Copyright©2003 Southwestern/Thomson Learning


Evaluating market equilibrium

 Because the equilibrium is an efficient allocation of


resources, the social planner can leave the market
outcome as he/she finds it.

 This policy of leaving markets alone goes by the


French expression laissez-faire.
Cases where efficiency does not occur

 If a market system is not competitive –if there is


monopoly - market power may result.

 Externalities are created when a cost or benefit


impacts on people – e.g. pollution.

 Markets do not allocate resources efficiently if market


failures occur.
Summary

 Consumer surplus measures the benefit buyers get


from participating in a market.

 Producer surplus measures the benefit sellers get from


participating in a market.

 An allocation of resources that maximises social


surplus is Pareto efficient.

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