Consumers, Producers,

and the Efficiency of Markets

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

PowerPoint Slides prepared by:

Andreea CHIRITESCU

Eastern Illinois University

Consumer Surplus

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• Welfare economics: Studies how resources affect well-being.

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Consumer Surplus

• Consumer surplus
• The difference between what a buyer is willing to pay (shown by demand curve) and what they actually pay.
• Graphically: area below demand curve, above price line.
• Price drop → existing buyers gain, new buyers enter.

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Table 1

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Four Possible Buyers’ Willingness to Pay

Figure 1

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The table shows the demand schedule for the buyers in Table 1. The graph shows the corresponding demand curve. Note that the height of the demand curve reflects buyers’ willingness to pay.

The Demand Schedule and the Demand Curve

Figure 2

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Measuring Consumer Surplus with the Demand Curve

In panel (a), the price of the good is $80, and the consumer surplus is $20. In panel (b), the price of the good is $70, and the consumer surplus is $40.

(a) Price = $80

(b) Price = $70

Figure 3

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How the Price Affects Consumer Surplus

In panel (a), the price is P₁, the quantity demanded is Q₁, and consumer surplus equals the area of the triangle ABC. When the price falls from P₁ to P₂, as in panel (b), the quantity demanded rises from Q₁ to Q₂, and the consumer surplus rises to the area of the triangle ADF. The increase in consumer surplus (area BCFD) occurs in part because existing consumers now pay less (area BCED) and in part because new consumers enter the market at the lower price (area CEF).

(a) Consumer Surplus at Price P₁

(b) Consumer Surplus at Price P₂

Consumer

surplus

Initial

consumer

surplus

Producer Surplus

• Producer surplus
• The price of an item minus the seller’s actual cost of production
• Area below the price and above the supply curve

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Table 2

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The Costs of Four Possible Sellers

Figure 4

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The Supply Schedule and the Supply Curve

The table shows the supply schedule for the sellers in Table 2. The graph shows the corresponding supply curve. Note that the height of the supply curve reflects sellers’ costs.

Figure 5

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Measuring Producer Surplus with the Supply Curve

In panel (a), the price of the good is $600, and the producer surplus is $100. In panel (b), the price of the good is $800, and the producer surplus is $500.

(a) Price = $600

(b) Price = $800

Figure 6

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How the Price Affects Producer Surplus

In panel (a), the price is P₁, the quantity supplied is Q1, and producer surplus equals the area of the triangle ABC. When the price rises from P₁ to P₂, as in panel (b), the quantity supplied rises from Q₁ to Q₂, and the producer surplus rises to the area of the triangle ADF. The increase in producer surplus (area BCFD) occurs in part because existing producers now receive more(area BCED) and in part because new producers enter the market at the higher price (area CEF).

(a) Producer Surplus At Price P₁

(b) Producer Surplus At Price P₂

Producer

surplus

Initial

producer

surplus

Market Efficiency

• The benevolent social planner
• All-knowing, all-powerful, well-intentioned dictator
• Wants to maximize the economic well-being of everyone in society
• Economic well-being of a society
• Total surplus = Sum of consumer and producer surplus

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Market Efficiency

• Market outcomes
1. Free markets allocate the supply of goods to the buyers who value them most highly
• Measured by their willingness to pay
2. Free markets allocate the demand for goods to the sellers who can produce them at the least cost

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Figure 7

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Consumer and Producer Surplus in the Market Equilibrium

Total surplus—the sum of consumer and producer surplus—is the area between the supply and demand curves up to the equilibrium quantity

Consumer

surplus

Producer

surplus

Market Efficiency

• Market outcomes

Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus

• Market equilibrium
• Efficient allocation of resources
• The benevolent social planner
• “Laissez faire” = “allow them to do”

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Market Efficiency

• Adam Smith’s invisible hand
• Free markets = best way to organize economic activity
• Allocate resources efficiently
• Several assumptions required
1. Markets are perfectly competitive
2. Market outcome matters only to the buyers and sellers in that market

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Market Efficiency & Failure

• When these assumptions fail, market equilibrium may be inefficient.
• Market power
• One or a few buyers or sellers can influence prices
• Externalities
• Market activity affects people outside the transaction.
• Public policy may correct these problems and improve efficiency.

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.