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


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


  • 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”


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


  • 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


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


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


  • 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


Initial Consumer Surplus

Consumer Surplus

Consumer Surplus to new buyers

P1

P1

P2

Additional

Consumer

Surplus to

Initial Buyers

Q1

Q1

Q2


  • 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

  • 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


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


  • 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


$0.90

$0.70

$0.50

$0.40

Chris’s Producer Surplus = $0.10

1

2

3

4


$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


  • 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


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

  • 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?

  • 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)


Consumer Surplus

Producer Surplus


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


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*


  • 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

  • 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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