Chapter 7

Consumers,
Producers, and the
Efficiency of Markets
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This chapter looks at the following:

 What is consumer surplus? How is it related to

the demand curve?
 What is producer surplus? How is it related to the
supply curve?
 Do markets produce a desirable allocation of
resources? Or could the market outcome be
improved upon?

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 Welfare economics
 Recall, the allocation of resources refers to:
• how much of each good is produced
• which producers produce it
• which consumers consume it
 Welfare economics:
the study of how the allocation of resources
affects economic well-being
 First, we look at the well-being of consumers.

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 Willingness to pay
Well being of consumers is measured by consumer surplus (CS).
To understand CS, we need to first understand willingness to pay.
A buyer’s willingness to pay for a good is the maximum amount
the buyer is willing to pay for that good.
WTP measures how much the buyer values the good.

Name WTP
Flea 300 Example:
4 buyers’ WTP
Anthony 250
for an iPod
Chad 175
John 125
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 WTP and the Demand Schedule

Derive the
P (price
demand who buys Qd
of iPod)
schedule:
$301 & up nobody 0
Between 250
Name WTP and 300 Flea 1
Between 175
Flea 300 and 250
Anthony, Flea 2
Anthony 250 Between 125 Chad, Anthony,
and 175
3
Flea
Chad 175
Between 0 John, Chad,
John 125 4
and 125 Anthony, Flea

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 WTP and the Demand Curve
P
$350
P Qd
$300
$250 $301 & up 0

$200 251 – 300 1

$150 176 – 250 2
$100
126 – 175 3
$50
0 – 125 4
$0 Q
0 1 2 3 4
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 WTP and the Demand Curve
P At any Q,
Flea’s WTP
$350 the height of
$300 Anthony’s WTP the D curve is
the WTP of the
$250 Chad’s WTP
John’s
marginal buyer,
$200 the buyer who
WTP
$150 would leave the
market if P were
$100 any higher.
$50
$0 Q
0 1 2 3 4
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 Consumer Surplus (CS)
Consumer surplus is the amount a buyer is willing
to pay minus the buyer actually pays:
CS = WTP – P

Name WTP Suppose P = $260.

Flea’s CS = $300 – 260 = $40.
Flea 300
The others get no CS because
Anthony 250
they do not buy an iPod at this
Chad 175 price. Their willingness to pay is
less than the price.
John 125
Total CS = $40.
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 CS and the Demand Curve
P
Flea’s WTP P = $260
$350
Flea’s CS =
$300 $300 – 260 = $40
$250 Total CS = $40
$200
$150
$100
$50
$0 Q
0 1 2 3 4
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 CS and the Demand Curve
P Instead, suppose
Flea’s WTP
$350 P = $220

Anthony’s WTP At this price, Flea and

$300 Anthony will buy the good.

$250
Flea’s CS =
$200 $300 – 220 = $80
Anthony’s CS =
$150 $250 – 220 = $30

$100 Total CS = $110

$50
$0 Q
0 1 2 3 4
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 CS and the Demand Curve
P
$350 The lesson:
$300 Total CS equals
the area under
$250 the demand curve
$200 and above the
price, from 0 to Q.
$150
$100
$50
$0 Q
0 1 2 3 4
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 CS with Lots of Buyers & a Smooth D
Curve
P The D curve in the previous slide looks like a
$350 staircase
with 4 steps – one per buyer.
$300
If there were a huge no. of buyers,
$250 as in a competitive market,
there would be a huge no.
$200
of very tiny steps,
$150 and it would look
$100 more like a smooth
curve.
$50
$0 Q
0 1 2 3 4
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CS with Lots of Buyers & a Smooth D Curve
CS is the area b/w
P and the D curve, P
from 0 to Q. $ 60
Recall: area of 50
a triangle equals h
½ x base x height 40

Height of 30
this triangle is 20 b
$60 – 30 = $30.
10
So, D
CS = ½ x 15 x $30 0 Q
= $225. 0 5 10 15 20 25 30
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 How a Lower Price Increases CS
At price = 40, the CS =A
P
At price 30, the CS 60
=A+B+C. So, there is an
increase in CS by B+C. 50
A
B is increase in CS due to 40
B
existing buyers, as they C
30
are now
paying lower price 20
C is increase in CS due to 10
additional buyers, who are D
now willing to buy the 0 Q
good at a lower price 0 5 10 15 20 25 30
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 Producer Surplus (benefit)
 Cost is the value of everything a seller must give up
to produce a good (i.e., opportunity cost).
 Includes cost of all resources used to produce good,
including value of the seller’s time, effort and
monetary expenses.
 Example: Costs of 3 sellers in the whitewash
business.
A seller will only produce and
Name cost sell the good if the price
exceeds his or her cost.
Angelo 10
Hunter 20
Hence, cost is a measure of
willingness to sell.
Kitty 35
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 Cost and the Supply Curve

P Qs
Derive the supply schedule
from the cost data: Below 10 0
Between
10 and 20 1
Between 20
and 35
2
name cost
35 & up 3
Angelo 10
Hunter 20
Kitty 35
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 Cost and the Supply Curve
P
$40 P Qs
Below 10 0
$30
Between
10 and 20
1
$20
Between
2
20 and 35
$10
35 & up 3
$0 Q
0 1 2 3
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 Cost and the Supply Curve
P At each Q, the
$40 height of the S curve
Kitty’s

$30 cost is the cost of the

marginal seller,
Hunter’s
$20 cost the seller who would
leave the market if
$10 Angelo’s cost the price were any
lower.
$0 Q
0 1 2 3
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 Producer Surplus
P PS = P – cost
$40 Producer surplus (PS):
the amount a seller
$30 is paid for a good
minus the seller’s cost.
$20

$10

$0 Q
0 1 2 3
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 Producer Surplus and the S Curve
P PS = P – cost
$40 Suppose P = $25.
Kitty’s
Angelo’s PS = $15 (25-10)
$30 cost Hunter’s PS = $5 (25-20)
Kitty’s PS = 0 (does not
Hunter’s participate at p=20, as her
$20 cost cost is 35)
Total PS = $20
$10 Angelo’s cost
Total PS equals the
area above the supply
$0 Q curve and under the
0 1 2 3 price, from 0 to Q.

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PS with Lots of Sellers & a Smooth S Curve
PS is the area b/w The supply of shoes
P
Price and the
Supply curve, from 60
b
0 to Q. 50 S
The height of this 40
triangle is
30
$40 – 15 = $25. h
20
So,
PS = ½ x b x h 10
= ½ x 25 x $25 0 Q
= $312.5
0 5 10 15 20 25 30
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 How a higher Price increases PS
At price 30, the PS =A
At price 40, the PS =A+B+C. So, P
there is an increase in PS by B+C.
60
B is increase in PS due to existing
sellers, as they are now
receiving higher price 50 S
C is increase in PS due to additional
sellers, who are now willing to sell the 40 C
good at a higher price B
30
A
20
10
0 Q
0 5 10 15 20 25 30
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What Do CS, PS, and Total Surplus Measure?

CS = (value to buyers) – (amount paid by buyers)

CS measures the benefit buyers receive
from participating in the market.

PS = (amount received by sellers) – (cost to sellers)

PS measures the benefit sellers receive
from participating in the market.

Total surplus = CS + PS
TS measures the total gains from trade in a market.

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 Measuring Society’s Well-Being
 Total surplus
= CS + PS
= (value to buyers) – (amount paid by buyers)
+ (amount received by sellers) – (cost to
sellers)
= (value to buyers) – (cost to sellers)

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 Efficiency
Total
surplus = (value to buyers) – (cost to sellers)

 An allocation of resources is efficient if it maximizes

total surplus. Efficiency means:
 The goods are being consumed by the buyers who
value them most highly.
 The goods are being produced by the producers with
lowest cost.
 Raising or lowering the quantity of a good would not
increase total surplus.
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 Does Market Allocation maximize TS
 In a market, the allocation of resources
is determined by the interactions
of many self-interested buyers and sellers.
 Is market’s allocation of resources desirable?
Does it maximizes total surplus? Or would a
different allocation of resources make society
better off?

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Which Buyers Get to Consume the Good?
Every buyer
P
whose WTP is
≥ $30 will buy. 60
50 S
Every buyer
whose WTP is 40
< $30 will not.
30
So, at market
equilibrium prices, the 20
buyers who value the 10
good most highly are D
the ones who 0 Q
consume it. 0 5 10 15 20 25 30
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 Which Sellers Produce the Good?
Every seller whose P
cost is ≤ $30 will
60
produce the good.
50 S
Every seller whose
cost is > $30 will 40
not. 30
Hence, at market 20
equilibrium prices,
the sellers with the 10
D
lowest cost produce 0 Q
the good. 0 5 10 15 20 25 30
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 Does Eq’m Q Maximize Total
Surplus?
 At Q = 20,
cost of producing P
the marginal unit
is $35 60
50 S
 value to consumers
of the marginal unit
is only $20
40
30
 Hence, can increase total
surplus by reducing Q. 20
10
D
0 Q
 This is true at any Q greater than 15 .0 5 10 15 20 25 30
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 Does Eq’m Q Maximize Total
Surplus?
 At Q = 10,
cost of producing P
the marginal unit 60
is $25
50 S
 value to consumers
of the marginal unit
40
is $40
 Hence, can increase total 30
surplus by increasing Q.
20
 This is true at any Q less
than 15.
10
D
0 Q
0 5 10 15 20 25 30
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 Evaluating the Market Eq’m: Summary
The market eq’m is efficient:
• The eq’m Q maximizes total surplus.
• The goods are produced by the producers with
lowest cost,
• and consumed by the buyers who value them
most highly.
The govt cannot improve on the market outcome.
Therefore, it should not interfere with the market.

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Why Non-Market Allocations Are Usually Bad
 Suppose the allocation of resources were instead
determined by a central planner
 To choose an efficient allocation, the planner
would need to know every seller’s cost
and every buyer’s WTP, for each of the
thousands of goods produced in the economy.
 This is practically impossible, so centrally planned
economies are never very efficient.

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