Welfare and efficiency
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Welfare and Efficiency . Consumer Surplus. Welfare Economics How allocation of resources affect economic well-being Willingness to pay Maximum amount that a buyer is willing to spend on a good (remember margins) – height of demand curve at a quantity Consumer Surplus

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Welfare and Efficiency

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Welfare and efficiency

Welfare and Efficiency


Consumer surplus

Consumer Surplus

  • Welfare Economics

    • How allocation of resources affect economic well-being

  • Willingness to pay

    • Maximum amount that a buyer is willing to spend on a good (remember margins) – height of demand curve at a quantity

  • Consumer Surplus

    • Willingness to pay minus amount paid


Welfare and efficiency

  • Think of the points on a demand curve as separate individuals

  • Each person only wants one cup of coffee

  • But each willing to pay a different maximum price

  • Construct a “market demand curve”

  • Start with a simplified “step demand curve”


Welfare and efficiency

Step Demand Curve

Price of Coffee

John’s Willingness to Pay

$1

Will’s Willingness to Pay

$0.80

Sam’s Willingness to Pay

$0.70

Tim’s Willingness to Pay

$0.50

1

2

3

4

Quantity Demanded

of Coffee


Welfare and efficiency

  • Demand Curve

    • Reflects People’s Willingness to Pay (height)

    • Helps measure consumer surplus

  • Consumer Surplus in a Market

    • Willingness to pay minus price paid

    • Graphically: Area between demand curve and price level


Welfare and efficiency

Step Demand Curve

Price of Coffee

Johns Consumer Surplus = $0.20

$1

$0.80

$0.70

$0.50

1

2

3

4

Quantity Demanded

of Coffee


Welfare and efficiency

Step Demand Curve

Price of Coffee

John’s Consumer Surplus = $0.30

$1

Will’s Consumer Surplus = $0.10

$0.80

$0.70

Total Consumer Surplus = $0.40

$0.50

1

2

3

4

Quantity Demanded

of Coffee


Welfare and efficiency

  • Buyers want to pay less, so lower price raises consumer surplus

  • At an initial P1, Q1 there is an initial surplus from first buyer

  • When price drops to P2 and quantity increases to Q2

    • Buyer one pays lower price

      • His consumer surplus increases

    • New buyer enters market

      • They have a consumer surplus


Welfare and efficiency

Initial Consumer Surplus

Consumer Surplus

Consumer Surplus to new buyers

P1

P1

P2

Additional

Consumer

Surplus to

Initial Buyers

Q1

Q1

Q2


Welfare and efficiency

  • Consumer Surplus

    • The benefit or gain buyers get from a transaction in the market

    • Measured from buyers point of view

  • Measure of Welfare

    • A good way to measure the economic well-being

    • Way to measure benefits from a market


Producer surplus

Producer Surplus

  • Way to think of Supply Curve

    • Supply Curve is willingness to accept

    • Lets say this is also their cost of production

  • Producer Surplus

    • Amount a seller receives for a good minus the cost of producing it

    • So the price level minus the height of the supply curve

  • Again lets start with a step supply curve where each seller sells one cup of coffee


Welfare and efficiency

Supply Curve for Coffee

$0.90

Alfred’s Cost of making a cup of coffee

$0.70

Linda’s Cost of making a cup of coffee

$0.50

Bob’s Cost of making a cup of coffee

$0.40

Chris’s Cost of making a cup of coffee

1

2

3

4


Welfare and efficiency

  • Supply Curve

    • Helps measure producer surplus

    • Viewed as willingness to accept (price they would take)

    • Viewed as cost of production

  • Producer Surplus

    • Difference between price received and cost of production

    • Area between price level and supply curve


Welfare and efficiency

$0.90

$0.70

$0.50

$0.40

Chris’s Producer Surplus = $0.10

1

2

3

4


Welfare and efficiency

$0.90

Total Producer Surplus = $0.50

$0.70

$0.50

Bob’s Producer Surplus = $0.20

$0.40

Chris’s Producer Surplus = $0.30

1

2

3

4


Welfare and efficiency

  • Sellers want to get more money, so a higher price raises producer surplus

  • At an initial P1, Q1 there is an initial surplus from first seller

  • When price increases to P2 and quantity increases to Q2

    • Seller one gets higher price

      • His producer surplus increases

    • New seller enters market

      • They have a producer surplus


Welfare and efficiency

Additional Producer Surplus to first seller

Producer surplus from new seller

P2

Producer Surplus

P1

P1

Initial Producer Surplus from first seller

Q1

Q1

Q2


Market efficiency

Market Efficiency

  • Maximizing the surplus in a market

    • Getting the most out of the market

  • Total Surplus

    • Consumer surplus plus producer surplus

    • Value to consumers minus cost to producers

  • Efficiency vs Equality

    • Efficiency

      • Property of resource allocation

      • An economy wide property

    • Equality

      • A property of how economic prosperity is distributed

      • Depends on individuals


How are markets efficient

How are Markets Efficient?

  • 1. Allocate the supply of goods to those who value them the most

    • Measured by willingness to pay

    • Height of demand curve (higher better)

  • 2. Allocate the demand for goods to producers who can make them at the lowest cost

    • Measured by willingness to accept

    • Height of supply curve (lower better)


Welfare and efficiency

Consumer Surplus

Producer Surplus


Equilibrium and efficiency

Equilibrium and Efficiency

  • Cannot Increase economic well being by:

    • Changing who consumes the good (changing allocation among buyers)

    • Changing who produces the good (changing allocation of production among sellers)

  • Cannot Increase economic well being by:

    • Increasing or decreasing the quantity in the market

    • So

  • 3. The Free Market chooses the quantity of good that maximizes total surplus


Welfare and efficiency

Buyers value good more than the cost of production so:

Make More

Buyers value good less than the cost of production so:

Make Less

Value to Buyers

Cost to Producers

Cost to Producers

Value to Buyers

Q*


Welfare and efficiency

  • So, Equilibrium is the Efficient allocation of resources

  • Market forces guide us to this point

  • Adam Smith’s ‘Invisible Hand’

  • Laissez faire = allow them to do

  • Conclusion

    • Free market best way to organize economy

    • Keep Gov’t hands off

  • But, only IF


The if s

The IF’s

  • Several Assumptions inherit in our conclusion

  • 1. Markets are perfectly competitive

    • No Market power

  • 2. Decisions of buyers and sellers only affect them and those in the market

    • No Externalities

  • When these are not true (market failure) our conclusion of unregulated market leading to best outcome may no longer be true


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