Welfare Economics and Market Efficiency: Consumer and Producer Surplus
Chapter 7: Welfare Economics
Key Questions
- 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?
What is Welfare Economics?
Welfare economics studies how the allocation of resources affects economic well-being. The allocation of resources refers to:
- How much of each good is produced
- Which producers produce it
- Which consumers consume it
First, we look at the well-being of consumers (buyers).
Willingness to Pay (WTP)
A buyer’s willingness to pay (WTP) for a good is the maximum amount the buyer will pay for that good. WTP measures how much the buyer values the good.
WTP and the Demand Curve
Q: If the price of an iPad is $200, who will buy an iPad, and what is the quantity demanded?
Derive the demand schedule:
About the Staircase Shape…
This demand curve looks like a staircase with 4 steps – one per buyer.
At any quantity (Q), the height of the demand curve is the WTP of the marginal buyer, the buyer who would leave the market if the price (P) were any higher.
Consumer Surplus (CS)
Consumer surplus is the amount a buyer is willing to pay minus the amount the buyer actually pays:
CS = WTP – P
CS and the Demand Curve
At Q = 5, the marginal buyer is willing to pay $50 for a pair of shoes.
Suppose P = $30.
Then her consumer surplus = $20.
CS is the area between P & the demand curve, from 0 to Q.
Recall: area of a triangle equals ½ x base x height
Height = $60 – 30 = $30.
So, CS = ½ x 15 x $30 = $225.
How a Higher Price Reduces CS
If P rises to $40,
CS = ½ x 10 x $20 = $100.
Two reasons for the fall in CS:
Active Learning 1: Consumer Surplus
Cost and the Supply Curve
Cost is the value of everything a seller must give up to produce a good (i.e., opportunity cost).
- Includes the cost of all resources used to produce the good, including the value of the seller’s time.
- Example: Costs of 3 sellers in a business.
Producer Surplus
Producer Surplus and the Supply Curve
Suppose P = $40.
At Q = 15 (thousand), the marginal seller’s cost is $30,
and her producer surplus is $10.
PS is the area between P and the supply curve, from 0 to Q.
The height of this triangle is $40 – 15 = $25.
So, PS = ½ x b x h = ½ x 25 x $25 = $312.50
How a Lower Price Reduces PS
If P falls to $30,
PS = ½ x 15 x $15 = $112.50
Two reasons for the fall in PS:
Active Learning 2: Producer Surplus
CS, PS, and Total Surplus
CS = (value to buyers) – (amount paid by buyers)
= buyers’ gains from participating in the market
PS = (amount received by sellers) – (cost to sellers)
= sellers’ gains from participating in the market
Total surplus = CS + PS
= total gains from trade in a market
= (value to buyers) – (cost to sellers)
The Market’s Allocation of Resources
In a market economy, the allocation of resources is decentralized, determined by the interactions of many self-interested buyers and sellers.
Is the market’s allocation of resources desirable? Or would a different allocation of resources make society better off?
To answer this, we use total surplus as a measure of society’s well-being, and we consider whether the market’s allocation is efficient.
(Policymakers also care about equality, though our focus here is on efficiency.)
Efficiency
An allocation of resources is efficient if it maximizes total surplus. Efficiency means:
- The goods are consumed by the buyers who value them most highly.
- The goods are produced by the producers with the lowest costs.
- Raising or lowering the quantity of a good would not increase total surplus.
Evaluating the Market Equilibrium
Market equilibrium:
P = $30
Q = 15,000
Total surplus = CS + PS
Is the market equilibrium efficient?
Which Buyers Consume the Good?
Every buyer whose WTP is ≥ $30 will buy.
Every buyer whose WTP is
So, the buyers who value the good most highly are the ones who consume it.
Which Sellers Produce the Good?
Every seller whose cost is ≤ $30 will produce the good.
Every seller whose cost is > $30 will not.
So, the sellers with the lowest cost produce the good.
Does Equilibrium Quantity Maximize Total Surplus?
At Q = 20,
cost of producing the marginal unit is $35
value to consumers of the marginal unit is only $20
Hence, we can increase total surplus by reducing Q. This is true at any Q greater than 15.
At Q = 10,
cost of producing the marginal unit is $25
value to consumers
of the marginal unit
is $40
Hence, can increase total surplus
by increasing Q.
This is true at any Q less than 15.
The market
eq’m
quantity maximizes
total surplus:
At any other quantity,
can increase
total surplus by moving toward
the market eq’m quantity.