CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

1. EC101- Chapter 7 PART THREE SUPPLY AND DEMAND – II MARKETS AND WELFARE CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS Chapter 7

2. EC101- Chapter 7 What did we learn so far? • Part One introduced us to some basic concepts as well as tools of economics as a science • Ten principles (Ch.1) • Thinking like an economist (Ch.2) • Exchange and trade (Ch.3) • Part Two introduced us to markets and how they work through the forces of supply and demand • Supply and Demand (Ch.4) • Elasticities (Ch.5) • Markets and government policies (Ch.6) • Part Three looks on the welfare implications of the market system

3. EC101- Chapter 7 What do we learn in this part? • We search for an answer to the following question • Are markets a good way to organise the social process of production? • To answer it we develop the concepts of consumer surplus, producer surplus and total surplus • They allow us to explain market efficiency • We then apply our new tools to understand the costs of taxation and the benefits of international trade • Part Three is made of • Ch.7 : Consumers, producers and market efficiency • Ch.8 : Application: Costs of taxation • Ch.9 : Application: International trade

4. EC101- Chapter 7 Market equilibrium revisited • Market equilibrium reflects the waymarkets allocate scarce resources • Supply and demand determines the equilibrium price and quantity for each good • Thus the resources that goes into its production as well as who shall benefit from its consumption • The next question is to find out if the equilibrium price and quantity maximize the total welfare of buyers and sellers? • Welfare economics answers this question • And determines whether the market allocation isdesirable or not from the perspective of society

5. EC101- Chapter 7 Welfare economics • Welfare economics study how the allocationofresources affects economic well-being in society • It uses a new concept called “surplus” • And shows that buyers and sellers both receive benefits fromtaking part in the market • Therefore the equilibrium in a market maximizesthe total welfare of buyers and sellers • Consumer surplus measures economic welfare from the buyer side • Producer surplus measures economic welfare from the sellerside • Together they allow us to evaluate the allocation of scarce resources by markets

6. EC101- Chapter 7 Willingness to pay • Willingness to payis the maximum price that a buyer is willing and able to pay for a good or service • It corresponds to the value attributed by the buyer to the good or service demanded • The willingness to pay cannot always be directly measured in the market but it is still there • How much a buyer will be willing to pay for a good or service is the maximum price at which he/she will purchase that good or service • What determines the maximum price? • The benefits that the buyer expect to receive from the consumption of that good or service

7. EC101- Chapter 7 Consumer surplus • Consumer surplus is the key concept of welfare economics • The market demand curve shows the various quantities that buyers would be willing and able to purchase at different prices • As the price goes down, the quantity bought goes up • Consumer surplus is the difference between the willingness to pay for the good or service and the actual spending for it • Consumer surplus is the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it

8. EC101- Chapter 7 Willingness to pay with four possible buyers

9. EC101- Chapter 7 Willingness to pay with four possible buyers

10. EC101- Chapter 7 Measuring consumer surplus with the demand curve Price of Album $100 John’s consumer surplus ($30) 80 Paul’s consumer surplus ($10) 70 Total consumer surplus ($40) 50 Demand 0 1 2 3 4 Quantity of Albums

11. EC101- Chapter 7 Consumer surplus, demand and price • Consumer surplus is the areathat lies below the demand curve and above the market price • Consumer surplus depends on the demand curve, which represents the willingness to pay • And the market price which represents market equilibrium • Ceteris paribus, changes in price and demand affect consumer surplus • Lower market price increases consumer surplus • Higher market price reduces consumer surplus • Higher demand increases consumer surplus • Lower demand reduces consumer surplus

12. How the price affects consumer surplus Price A Initial consumer surplus C Consumer surplus P1 B to new consumers F P2 D E Additional consumer surplus to initial Demand consumers 0 Q1 Q2 Quantity

13. EC101- Chapter 7 Willingness to sell • We can now apply the concept of surplus to the producers • Market supply curve shows the various quantities that producers would be willing and able to sell at different prices • It may be seen as a measure of supplier costs, that is, the opportunity cost ofsupplying various quantities of thegood. • The marginal opportunity cost ofproduction increases as market output expands • Because a producer’s cost is the lowestprice he/she will accept, cost is a measure of his/her willingness to sell

14. EC101- Chapter 7 Producer surplus • Producer surplus is the symetric image of consumer surplus on the supply curve • It is measured by the difference between the willingness to sell of the producers for a good or service and the actual revenue they receive from it • Producer surplus is therefore the amount a seller is paid minus the cost of production of the good or service • It is the area that lies above the supply curve and below the price line • Producer surplus measures the benefit to sellers of participating in a market

15. EC101- Chapter 7 The costs of four possible sellers

16. EC101- Chapter 7 Supply schedule withfour possible sellers

17. EC101- Chapter 7 Measuring producer surplus with the supply curve Price of House Painting Supply Total producer surplus ($500) $900 800 Georgia’s producer surplus ($200) 600 500 Grandma’s producer surplus ($300) 0 1 2 3 Quantity of Houses Painted

18. EC101- Chapter 7 How price affects producer surplus Price Supply Additional producer surplus to initial producers E D P2 F B P1 C Initial producer surplus Producer surplus to new producers A 0 Q1 Q2 Quantity

19. EC101- Chapter 7 Market efficiency • The sum of consumer surplus and producer surplus is a good measure of the well-being of society • A market with perfect competition and without externatilities maximises society’s well-being • Consumer surplus = value to buyers – amount paid by buyers • Produces surplus = amount received by sellers – cost to sellers • Total surplus = value to buyers – cost to sellers • Market efficiencyis attained when the allocation of resources maximizes total surplus • Competitive markets are therefore efficient

20. EC101- Chapter 7 Efficiency versus equity • It is very important to understand the limitations of the word “efficiency” • In an efficient solution, nobody can be better off without someone else becoming worse off • If it possible to increase one person’s well-being without reducing that of the others the solution is clearly inefficient • But efficiency does not mean equity nor equality • Our sense of fairness may not be satisfied with an efficient situation which corresponds to a very unequal distribution of well-being among members of society • Equity is also very important for society

21. EC101- Chapter 7 Price A D Supply Consumer surplus Equilibrium price E Producer surplus Demand B C 0 Quantity Equilibrium quantity Consumer and producer surplus in the market equilibrium

22. EC101- Chapter 7 Price Supply Value Cost to to buyers sellers Cost Value to to sellers buyers Demand 0 Equilibrium Quantity quantity Value to buyers is greater Value to buyers is less than cost to sellers. than cost to sellers. Efficiency of equilibrium

23. EC101- Chapter 7 Market efficiency: three observations • Welfare economics allow us to evaluate the meaning and benefits of a market economy for the society • We highlight three aspects that makes the market economy desirable for society • Free and competitive markets allocate the supply of goods to the buyers who value them most highly • Free and competitive markets allocate the demand for goods to the sellers who can produce them at least cost • Free and competitive markets produce the quantity of goods that maximizes the sum of consumer and producer surplus

24. EC101- Chapter 7 Market as an “invisible hand” • In a free market there is no centralised social authority to allocate scarce resources • The many buyers and sellers in a market economy are motivated by self-interest, not by altruism • A process of coordination andcommunication takes place so that buyers and sellers are directed to themost efficient outcome • As if by an invisible hand, the free market system reaches efficiency • Scottish economist Adam Smith first coined the term “invisible hand” in his book The Wealth of Nations, published in 1776

25. EC101- Chapter 7 Tickets on the sidewalk • Let us look at an interesting example • Assume you decide to go to a show or a football game at the last minute? • Your only chance is to go to the theater or the stadium with the hope that someone will be selling tickets • But you have to pay a higher price • Is it “black market”? Or is it a service? • For the economist the enterpreneurs who buy tickets in advance to sell them with profit at the door take risks which explain their profits • The economist will be worried about whether they pay or not income tax on this income

26. EC101- Chapter 7 Market failure: market power and externalities • Market poweris the ability of one buyer or seller to control market price • Market power reduces total surplus • It is called market failure because it causes markets to be inefficient • Externalitiesare the benefits or costsimposed on a third party who is not theconsumer or the producer • Such as the cost of pollution to the society which is not included in the price of the good • Externalitiesresult in lower total surplus • Causing markets to be inefficient, and thus fail

27. EC101- Chapter 7 Conclusion • Welfare economics evaluate the market from the perspective of society • Consumer and producer surplus measures the benefits of buyers and sellers from participating in the market • An allocation of resources that maximizes the sum of consumer and producer surplus is said to be efficient • Policymakers are concerned with efficiency and also equity • Market power and externalities can cause markets to be inefficient and to fail