Welfare and Efficiency

1. Welfare and Efficiency

2. 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

3. 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”

5. 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

6. 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

7. 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

8. 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

9. 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

10. Initial Consumer Surplus Consumer Surplus Consumer Surplus to new buyers P1 P1 P2 Additional Consumer Surplus to Initial Buyers Q1 Q1 Q2

11. 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

12. 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

13. 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

14. 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

15. $0.90 $0.70 $0.50 $0.40 Chris’s Producer Surplus = $0.10 1 2 3 4

16. $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

17. 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

18. 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

19. 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

20. 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)

21. Consumer Surplus Producer Surplus

22. 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

23. 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*

24. 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

25. 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