CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

J. Mao

Welfare Economics

¨  Recall, the allocation of resources refers to: ¤  how much of each good is produced ¤  which producers produce it ¤  which consumers consume it

¨  Welfare Economics studies how the allocation of resources affects economic well-being

Willingness to Pay (WTP)

¨  A buyer’s willingness to pay for a good is the maximum amount the buyer will pay for that good.

¨  WTP measures how much the buyers values the good.

Buyer Willingness to Pay

John $100

Paul 80

George 70

Ringo 50

Willingness to Pay (WTP)

¨  Q: If price of the good is $75, who will buy, and what is quantity demanded?

Buyer Willingness to Pay

John $100

Paul 80

George 70

Ringo 50

Buyer Willingness to Pay

John $100

Paul 80

George 70

Ringo 50

Price Buyer QuantityDemanded

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 Ringo 4

WTP and the Demand Curve

¨  What will the Demand Curve look like for this market?

WTP and the Demand Curve

Price of Album

50

70

80

0

$100

1 2 3 4 Quantity of Albums

John’s willingness to pay

Paul’s willingness to pay

George’s willingness to pay

Ringo’s willingness to pay

Demand

WTP and the Demand Curve

¨  At any Q, the height of the D curve is the WTP of the marginal buyer, the buyer who would leave the market if P were any higher

Consumer Surplus

¨  Consumer surplus is the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it.

¨  CS = WTP - P

CS and the Demand Curve

Price of Album

50

70

80

0

$100

1 2 3 4 Quantity of Albums

Demand

John’s consumer surplus ($20)

Price = $80

CS and the Demand Curve

Price of Album

50

70

80

0

$100

1 2 3 4 Quantity of Albums

Demand

John’s consumer surplus ($30)

Total consumer surplus ($40)

Price = $70

Paul’s consumer surplus ($10)

CS with smooth demand CS with smooth demand

Prof Jonathan Wolff ( Department of Economics University of Notre Dame)Principles of Micro Economics September 17th, 2012 13 / 41

Q2

P2

How Price Affects CS

Quantity

Price

0

Demand

Initial consumer surplus

Additional consumer surplus to initial consumers

Consumer surplus to new consumers

Q1

P1

D E F

B C

A

Welfare Economics

¨  CS measures the benefit that buyers receive from a good as the buyers themselves perceive it.

¨  CS is a good measure of economic well-being if we respect the preferences of buyers.

¨  Economists normally assume ¤  buyers are rational when they make decisions. ¤  People’s preferences should be respected and consumers

are the best judges of how much benefit they receive from the goods they buy.

¤  What about the preferences of drug addicts? Do addicts get a large benefit from being able to buy heroin at a low price?

Cost and the Supply Curve

¨  Cost is the value of everything a seller must give up to produce a good (i.e., opportunity cost).

¨  Includes cost of all resources used to produce goods, including value of the seller’s time.

¨  A seller will produce and sell the good/service only if the price exceeds his or her cost.

¨  Hence, cost is a measure of willingness to sell.

Seller Cost

Mary $900

Frida 800

Georgia 600

Grandma 500

Price Sellers QuantitySupplied

$900 or more Mary, Frida, Georgia,Grandma

4

$800 to $900 Frida, Georgia, Grandma 3

$600 to $800 Georgia, Grandma 2

$500 to $600 Grandma 1

Less than $500 None 0

Cost and the Supply Curve

Quantity of Houses Painted

Price of House

Painting

500

800

$900

0

600

1 2 3 4

Grandma’s cost

Georgia’s cost

Frida’s cost

Mary’s cost

Supply

Cost and the Supply Curve

¨  At any Q, the height of the S curve is the cost of the marginal seller, the seller who would leave the market if P were any lower

Producer Surplus

◆ Producer surplus is the amount a seller is paid minus the cost of production.

◆ PS = P - C

Quantity of Houses Painted

Price of House

Painting

500

800

$900

0

600

1 2 3 4

Supply

Grandma’s producer surplus ($100)

Price = $600

Producer Surplus

Producer Surplus

Quantity of Houses Painted

Price of House

Painting

500

800

$900

0

600

1 2 3 4

Supply

Grandma’s producer surplus ($300)

Price = $800

Georgia’s producer surplus ($200)

Total producer surplus ($500)

P2

Q2

How Price Affects PS

Quantity

Price

0

Supply

Q1

P1

A

B C Initial

Producer surplus

Additional producer surplus to initial producers

D E F

Producer surplus to new producers

CS and PS

¨  Consider the market for good A ¨  Suppose the costs of inputs for A fall, how would the

market equilibrium change and how would CS and PS change?

Total Surplus

¨  CS and PS are the basic tools to study and evaluate welfare of buyers and sellers

¨  CS = (value to buyers)-(amount paid by buyers) = buyers’ gains from participating in the market

¨  PS = (amount received by sellers)-(cost to sellers) = sellers’ gains from participating in the market

¨  Total Surplus = CS + PS = total gains from trade in the market =(value to buyers)-(cost to sellers)

The Market’s Allocation of Resources

¨  In a market economy, the allocation of resources is decentralized, determined by the interactions of many self-interested buyers and sellers.

¨  Is the market’s allocation desirable? Would a different allocation make society better off?

¨  To answer the question, we need a measure of society’s well-being

Market Efficiency

◆ An allocation of resources is efficient if it maximizes total surplus.

Efficiency vs. Equality

¨  Efficiency – An allocation of resources that maximize total surplus.

¨  Equity – The fairness of the distribution of well-being among the members of society.

¨  The question of efficiency is whether the pie is as big as possible.

¨  The question of equity is whether the pie is divided fairly.

Evaluating the Market Equilibrium Evaluating the Market Equilibrium

Prof Jonathan Wolff ( Department of Economics University of Notre Dame)Principles of Micro Economics September 17th, 2012 32 / 41

Which buyers consume the good? Which buyers consume the good?

Prof Jonathan Wolff ( Department of Economics University of Notre Dame)Principles of Micro Economics September 17th, 2012 33 / 41

Which sellers produce the good? Which sellers produce the good?

Prof Jonathan Wolff ( Department of Economics University of Notre Dame)Principles of Micro Economics September 17th, 2012 34 / 41

Efficient Allocation of Consumption and Production

◆ Market allocates goods to buyers who value it most highly

◆ Market allocates production of goods to sellers who can produce at lower cost

Price

0 Quantity Equilibrium quantity

Supply

Demand

Cost to sellers

Value to buyers

Value to buyers

Cost to sellers

Value to buyers is greater than cost to sellers.

Value to buyers is less than cost to sellers.

Efficient Quantity

First Welfare Theorem

¨  Assume 1.  Market structure is perfectly competitive (not

monopoly or oligopoly) 2.  No externalities (my action hurts or benefits

others, but I don’t take into account. Like pollution)

¨  Then the unregulated market (laissez-faire) allocation is efficient ¤  No other outcome achieves higher total surplus

First Welfare Theorem

¨  The First Welfare Theorem also sometimes called the Invisible Hand Theorem

¨  Now while the market maximizes the size of the pie (under the assumptions given above), you might not like the way it is divided up.

¨  Market delivers on efficiency, not necessarily on equity