Consumers, Producers, and the Efficiency of Markets

1. Consumers, Producers, and the Efficiency of Markets Outline: • Positive economics: Allocation of scarce resources using forces of demand and supply • Normative economics: Whether these allocations are desirable leads to the study of welfare economics • Welfare economics is the study of how the allocation of resources affects economic wellbeing • Examine the benefits that buyers and sellers receive from participating in the market • Willingness to pay is the maximum amount that a buyer will pay for a good

2. Consumer Surplus and Demand Curve • Consumer surplus is a buyer’s willingness to pay minus the amount the buyer actually pays • Using the willingness to pay of the buyers one can derive the demand schedule and the demand curve • The height of the demand curve shows the willingness to pay of the marginal buyer • Consumer surplus in a market is measured as the area below the demand curve and above the market price Consumer Surplus P DD Q

3. Consumer Surplus and Demand Curve • A lower price raises consumer surplus • Existing buyers see an increase in their consumer surplus due to a reduction in price • New buyers enjoy consumer surplus as they can now enter the market • Consumer surplus is a good measure of economic well-being and respects preferences of consumers. Is it always a good measure? • Important assumption in economics- consumers are rational

4. Producer Surplus and Supply Curve • Cost is the value of everything a seller must give up to produce. It includes the cost of raw materials and the opportunity cost (value of her time). Cost is a measure of the seller’s willingness to sell. • Producer surplus is the amount a seller is paid for a good minus the seller’s cost. It measures the benefit to the sellers for participating in a market. • The willingness to sell or cost is used to derive the supply schedule and graph the supply curve.

5. Producer Surplus and Supply Curve • The height of the supply curve measures the sellers’ costs. The price on the supply curve denotes the cost of the marginal seller • Producer surplus in a market is the area below the price and above the supply curve • A higher price raises producers surplus by • Existing producers receive a higher price • New producers enter the market at a higher price

6. Market Efficiency • Consumer surplus= value to buyers- amount paid by buyers • Producer surplus= amount received by sellers- cost to sellers • Therefore, market surplus= value to buyers- cost to sellers • If the allocation of resources maximizes total surplus then that allocation is efficient • Efficiency is the property of a resource allocation of maximizing the total surplus received by all members of society • Equity is the fairness of the distribution of well-being among the members of society

7. Market Efficiency • Free markets allocate the supply of goods to the buyers who value them most • Free markets allocate the demand for goods to the sellers who produce them at least cost • Free markets produce the quantity of goods that maximizes total surplus in the market • Conclusion: Free markets result in efficient market outcomes but are the market outcomes equitable?

8. Market Failure • Efficiency of markets is based on two major assumptions: • Markets are perfectly competitive • Market outcomes matter only to the buyers and sellers in the market • Assumptions are invalid in some cases and result in market failure- the inability of some unregulated markets to allocate resources efficiently • Causes for market failure • Existence of market power • Presence of externalities • Free markets produce the quantity of goods that maximizes total surplus in the market • Conclusion: Free markets result in efficient market outcomes but are the market outcomes equitable?