DEFINITION

Welfare Economics is the study of how the allocation of resources affects economic well-being.

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.

WILLINGNESS TO PAY
At a higher price a smaller quantity would be demanded, i.e., willingly purchased. At the higher price some buyers would stop being willing to pay to buy.

P* P

Q*

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.

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.

WILLINGNESS TO PAY
Then there is some buyer that is willing to pay price p1 for the first unit of the good; And some buyer willing to pay p2 for the second unit of the good; etc.

P1 P2

Pn

1 2

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.

100

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*

100

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*

100

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

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

B
P* P**

E D

100 125

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
P* P**

E D

100 125

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.

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.

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.

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.

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).
Q*

P*

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*

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*

Q*

MARKET EQUILIBRIUM
The total surplus is consumer surplus + producer surplus, area A + area B.

A
B

MARKET EQUILIBRIUM
The total surplus = (Value to buyers - PE) +(PE - Cost to sellers) =Value to buyers Cost to sellers.

A
B

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

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.

DEFINITION
Economic efficiency occurs when resources are allocated so that social welfare is maximized.

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;

QA

QB

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,

QA

QB

ECONOMIC EFFICIENCY
while producing any units beyond Q* reduces social welfare. Therefore allocating resources to produce Q* units of output maximizes social welfare.

QA

QB

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.

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.

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.

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

INTERFERENCE WITH MARKET FORCES

a

DEADWEIGHT LOSS

A
P* PC b

B
c
QC Q*

When the market is free of restrictions, the equilibrium price and quantity will be P* and Q*. Consumer surplus will be triangle P*ba, and producer surplus will be triangle P*bc.

INTERFERENCE WITH MARKET FORCES

a

DEADWEIGHT LOSS

A
P* PC b

B
c
QC Q*

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.

INTERFERENCE WITH MARKET FORCES

a

DEADWEIGHT LOSS

A
P* PC b

B
c
QC Q*

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

INTERFERENCE WITH MARKET FORCES

a

DEADWEIGHT LOSS

A
P* PC b

B
c
QC Q*

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*

INTERFERENCE WITH MARKET FORCES

a

DEADWEIGHT LOSS

A
P* PC b

B
c
QC Q*

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

INTERFERENCE WITH MARKET FORCES

a

DEADWEIGHT LOSS

A
P* PC b

B
c
QC Q*

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.