Consumers, Producers, and

the Efficiency of Markets

 Consumer Surplus
• Welfare economics
 How the allocation of resources affects economic
well-being
• Willingness to pay
 Maximum amount that a buyer will pay for a good
• Consumer surplus
 Amount a buyer is willing to pay for a good-- amount
the buyer actually pays for it

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Table

Four possible buyers’ willingness to pay

Buyer Willingness to pay

John $100
Paul 80
George 70
Ringo 50

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Figure
The demand schedule

Quantity
Price Buyers Demanded
More than $100 None 0
$80 to $100 John 1
$70 to $80 John, Paul 2
$50 to $70 John, Paul, George 3
$50 or less John, Paul, George, Ringo 4

The table shows the demand schedule for the buyers in Table 1.

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Figure
The demand curve
Price of
Albums
John’s willingness to pay
$100 Paul’s willingness to pay

80 George’s willingness to pay

70

Ringo’s willingness to pay

50

Demand

0 1 2 3 4
Quantity of Albums

The graph shows the corresponding demand curve. Note that the
height of the demand curve reflects buyers’ willingness to pay 5
 Figure
Measuring consumer surplus with the demand curve
(a) Price = $80 (b) Price = $70
Price of Price of
Albums Albums
John’s consumer
John’s consumer surplus ($30)
$100 surplus ($20)
$100
Paul’s consumer
80 80 surplus ($10)
70 70

50 50
Total consumer
surplus ($40)

Demand Demand

0 1 2 3 4 0 1 2 3 4
Quantity of Albums Quantity of Albums

In panel (a), the price of the good is $80, and the consumer surplus is $20. In
panel (b), the price of the good is $70, and the consumer surplus is $40. 6
Figure
How the price affects consumer surplus
(a) Consumer surplus at price P1 (b) Consumer surplus at price P2
Price Price

A A

Additional consumer
surplus to initial
Initial consumers
Consumer consumer
surplus C surplus C
P1 Consumer surplus
P1 to new consumers
B B
F
P2
Demand D E Demand

0 Q1 Quantity 0 Q1 Q2 Quantity

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 Consumer Surplus
• What does consumer surplus measure?
• Consumer surplus
– Benefit that buyers receive from a good
• As the buyers themselves perceive it
– Good measure of economic well-being
– Exception: Illegal drugs
• Drug addicts
– Willing to pay a high price for heroin
• Society’s standpoint
– Drug addicts don’t get a large benefit from being able to
buy heroin at a low price
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 Producer Surplus
• Supply decided by the Cost and the willingness to sell
• Cost
Value of everything a seller must give up to
produce a good

• Producer surplus
Amount a seller is paid for a good- Minus the
seller’s cost of providing it

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Table
The costs of four possible sellers

Seller Willingness to pay

Mary $900
Frida 800
Georgia 600
Grandma 500

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Figure
The supply schedule

Quantity
Price Sellers Supplied

$900 or more Mary, Frida, Georgia, Grandma 4

$800 to $900 Frida, Georgia, Grandma 3
$600 to $800 Georgia, Grandma 2
$500 to $600 Grandma 1
Less than $500 None 0

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Figure
The supply curve
Price of
House Supply
Painting

$900 Mary’s cost

800
Frida’s cost

600 Georgia’s cost

500
Grandma’s cost

0 1 2 3 4
Quantity of Houses Painted

The graph shows the corresponding supply curve. Note that the
height of the supply curve reflects sellers’ costs. 12
 Figure
Measuring producer surplus with the supply curve
(a) Price = $600 (b) Price = $800
Price of Price of
House Supply House Supply
Painting Painting Total producer
surplus ($500)
$900 $900
800 800

600 600
500 Grandma’s producer 500 Georgia’s producer
surplus ($100) surplus ($200)

Grandma’s producer
surplus ($300)

0 1 2 3 4 0 1 2 3 4
Quantity of Houses Painted Quantity of Houses Painted

In panel (a), the price of the good is $600, and the producer surplus is $100. In
panel (b), the price of the good is $800, and the producer surplus is $500. 13
Figure
How the price affects producer surplus
(a) Producer surplus at price P1 (b) Producer surplus at price P2
Price Price
Supply Additional producer Supply
surplus to initial
producers

D E F
P2

Producer surplus
B B to new producers
P1 P1
C Initial
C
Producer
surplus consumer
surplus

A A
0 Q1 Quantity 0 Q1 Q2 Quantity

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 Market Efficiency
• The benevolent social planner
 All-knowing, all-powerful, well-intentioned dictator
 Wants to maximize the economic well-being of everyone in
society
• Economic well-being of a society
 Total surplus = Sum of consumer and producer surplus

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 Market Efficiency
• The benevolent social planner
 Total surplus = Consumer surplus + Producer surplus
• Consumer surplus = Value to buyers – Amount paid by
buyers
• Producer surplus = Amount received by sellers – Cost to
sellers
 Total surplus = Value to buyers – Cost to sellers

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 Market Efficiency
• Efficiency
– Property of a resource allocation
– Maximizing the total surplus
• Received by all members of society
• Equality
– Property of distributing economic prosperity
– Uniformly among the members of society

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 Market Efficiency
• Evaluating the market equilibrium
• Market outcomes
1. Free markets allocate the supply of goods to the
buyers who value them most highly
• Measured by their willingness to pay
2. Free markets allocate the demand for goods to the
sellers who can produce them at the least cost

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Figure
Consumer and producer surplus in the market equilibrium

Price
A Supply

D
Consumer
surplus
Equilibrium E
price
Producer
surplus

Demand
C
0 Equilibrium Quantity
quantity
Total surplus—>the sum of consumer and producer surplus

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 Market Efficiency
• Evaluating the market equilibrium
Social planner
• Cannot increase economic well-being by
Changing the allocation of consumption among buyers
Changing the allocation of production among sellers
• Cannot rise total economic well-being by
Increasing or decreasing the quantity of the good
3.Free markets produce the quantity of goods that maximizes
the sum of consumer and producer surplus

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 Figure 8
The efficiency of the equilibrium quantity
Price
Supply

Value Cost
to to
buyers sellers

Demand

Cost Value
to to
sellers buyers
0 Q1 Equilibrium Q2
quantity Quantity

Value to buyers is Value to buyers is less

greater than cost to than cost to sellers
sellers
At quantities less than the equilibrium quantity, such as Q 1, the value to buyers exceeds the cost to
sellers. At quantities greater than the equilibrium quantity, such as Q 2, the cost to sellers exceeds
the value to buyers. Therefore, the market equilibrium maximizes the sum of producer and 21
consumer surplus.
 Market Efficiency
• Evaluating the market equilibrium
• Adam Smith’s invisible hand
– Takes all the information about buyers and
sellers into account
– Guides everyone in the market to the best
outcome
• Economic efficiency
• Free markets = best way to organize
economic activity
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 Should there be a market in organs?

• “How a mother’s love helped save two lives”

– Ms. Stevens - her son needed a kidney transplant
– The mother’s kidney was not compatible
– Donated one of her kidneys to a stranger
– Her son – move to the top of the kidney waiting list

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 Market Efficiency & Market Failure
• Forces of supply and demand allocate
resources efficiently
– Several assumptions about how markets work
1. Markets are perfectly competitive
2. Outcome in a market matters only to the buyers
and sellers in that market
– When these assumptions do not hold
• Our conclusion that the market equilibrium is
efficient may no longer be true

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 Market Efficiency & Market Failure
• In the world
– Competition - far from perfect
• Market power
– A single buyer or seller (small group)
– Control market prices
– Markets are inefficient
» Keeps the price and quantity away from the equilibrium of
supply and demand

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 Market Efficiency & Market Failure
• In the world
– Decisions of buyers and sellers
• Affect people who are not participants in the
market at all
• Externalities
– Cause welfare in a market to depend on more than
just the value to the buyers and the cost to the sellers
• Inefficient equilibrium
– From the standpoint of society as a whole

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 Market Efficiency & Market Failure
• Market failure
– E.g.: market power and externalities
– The inability of some unregulated markets to
allocate resources efficiently
– Public policy
• Can potentially remedy the problem
• Increase economic efficiency

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