Transcript Mankiw:Chapter 7 - Villanova University

Chapter 7
Consumers, Producers and
the Efficiency of Markets
Objectives
1. Understanding how consumer’s
willingness and ability to pay for
a good determines the demand
curve.
2. Learn the concept of consumer
surplus and how to measure it.
3. Understand how sellers cost of
production determine the supply
curve.
Objectives
4. Learn the concept of producer
surplus and how to measure it,
and ...
5. ... recognize that market
equilibrium maximizes total
surplus in a market.
Market Equilibrium Revisited
Does the equilibrium price and quantity result in
the maximum total welfare of buyer and seller?
S
PE
D
QE
Market Equilibrium Revisited
Does the equilibrium price and quantity result in
the maximum total welfare of buyer and seller?
Market
equilibrium illustrates the way
markets allocate scarce resources.
But does it answer whether that market
allocation is desirable?
Turn to Welfare Economics to answer
the question.
Welfare Economics
Is
the study of how the allocation of
resources affects economic well being.
–
Buyers and sellers receive benefits from
taking part in the market.
–
The equilibrium in a market makes the
sum of these benefits as large as
possible.
Welfare Economics
Equilibrium
in the market results in
maximum benefits, and therefore
total welfare for both the buyer and
the seller.
Welfare
Economics from the
Buyer Side and the Seller Side:
–
Consumer Surplus
–
Producer Surplus
Welfare Economics: Consumer Surplus
Market
Demand Curve: depicts the
various quantities that buyers would
want to purchase at different prices.
What
determines how much a
consumer would be willing to pay (the
maximum price) for a good or service?
–
Answer: The expected benefits received
or Utility.
Utility is...
… the satisfaction
(benefit) that a
consumer expects to
receive from
consuming a good or
service.
…the power to satisfy
a want.
Marginal Utility (MU) is...
…the amount of utility (satisfaction)
that one more or one less unit of
consumption adds to or subtracts from
total utility.
–
Consumers try to obtain the largest
possible total satisfaction (utility) from
the mix of goods and services they buy
with their incomes.
Consumer Surplus is...
…the maximum amount a consumer
will be willing to pay for a good
depends upon the expected utility
(benefits) of that good.
–
Willingness to Pay:
The
maximum price that a buyer is willing
and able to pay for a good.
Measures
how much the buyer values the
good or service.
Measuring Consumer Surplus
with the Demand Curve
Price of
Album
$100
John’s consumer
surplus ($10)
80
Paul’s consumer
surplus ($10)
70
Total consumer
surplus ($40)
50
Demand
0
1
2
3
4
Quantity of
Albums
Four Possible Buyers’ Willingness to
Pay...
Price
Buyer
Quantity
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
Ringo
4
Consumer Surplus: Verbal Definition
 The
amount a buyer
is willing to pay for a
good minus the
amount the buyer
actually pays for it.
D
How the Price Affects Consumer Surplus
Figure 7-3 (a) -- Consumer Surplus at Price P1
Price
A
Consumer Surplus
P1
B
C
Demand
0
Q1
Quantity
How the Price Affects Consumer Surplus
Figure 7-3 (b) -- Consumer Surplus at Price P2
Price
A
Initial Consumer Surplus
Additional consumer surplus
to initial consumers
P1
P
2
C
B
Consumer Surplus to
New Consumers
F
D
E
Demand
0
Q1
Q
2
Quantity
Consumer Surplus: Graphical
S
Pmax
Consumer
Surplus
PE
D
QE
Consumer Surplus and Market Price
The
area below the demand curve and
above the market price measures the
consumer surplus in a market. Hence,
–
A lower market price will increase
consumer surplus
–
A higher market price will reduce
consumer surplus
Consumer Surplus and Economic
Well-Being
Consumer surplus, the amount
that buyers are willing to pay for a
good minus the amount they
actually pay for it, measures the
benefit that buyers receive from a
good as the buyers themselves
perceive it.
Consumer Surplus: Mathematically
Maximum
Market
Price = $11
Price = $6
Quantity
Purchased = 6
Assume:
Price drops $1 for every
additional unit sold.
Consumer
Surplus = $15
$51 - $36 = $15
($11+$10+$9+$8+$7+$6) - ($6 x 6) = $15
$11
$10
$9
$8
$7
Market
Price
$6
D
1
2
3
4
5
6
Quantity Purchased
$11
$10
Total Consumer
Benefits
$9
$8
$7
$6
D
1
2
3
4
5
6
$11
$10
$9
$8
Consumers
Expense
$7
$6
D
1
2
3
4
5
6
$11
Consumer Benefit
-Consumer Expense
$10
CONSUMER SURPLUS!
$9
$8
$51 - $36 =
$7
$15
$6
D
1
2
3
4
5
6
Quick Quiz
 Illustrate,
with a demand
curve, the consumer
surplus for turkey.
 Explain
in words what
consumer surplus
measures.
 Discuss
changes in
consumer surplus as price
changes.
Producer Surplus
Market
Supply Revisited:
–
Depicts the various quantities that
suppliers would be willing to sell at
different prices.
–
May be viewed as a measure of supplier
costs, i.e.. the opportunity cost to the
seller of supplying various quantities of
the good.
Producer Surplus
Market
Supply: The marginal
opportunity cost of production
increases as market output expands.
Because
the producer’s cost is the
lowest price he/she would accept it
may be considered a measure of
his/her willingness to sell.
Measuring Consumer Surplus
with the Supply Curve
Price of
House
Painting
Supply
Total producer
surplus ($500)
$900
800
Georgia’s producer
surplus ($200)
600
500
Grandma’s producer
surplus
0
1
2
3
4
Quantity of
Houses Painted
Figure 7-5a
The Costs of Four Possible
Sellers...
Seller
Cost
Mary
$900
Frida
800
Georgia
600
Grandma
500
Producer Surplus: Verbal Definition
 The
amount a seller is
paid minus the cost
of production.
 Producer
surplus
measures the benefit
to sellers of
participating in a
market.
S
How the Price Affects Producer Surplus
Figure 7-6 (a) -- Producer Surplus at Price P1
Price
Supply
P1
B
C
A
0
Producer
Surplus
Q1
Quantity
How the Price Affects Producer Surplus
Figure 7-6 (b) -- Producer Surplus at Price P2
Additional producer
surplus to initial
producers
Price
Supply
D
P
E
F
2
P1
C
A
0
Producer surplus
to new producers
B
Producer
Surplus
Q1
Q
2
Quantity
Producer Surplus: Mathematically
Minimum
Market
Price = $1
Price = $6
Quantity
Sold = 5
Assume:
Price increases $1 for every
additional unit sold.
Producer
Surplus = $15
$30 - $15 = $15
($6 x 5) - ($1 +$2 + $3 + $4 + $5) = $15
S
$6
$5
$4
$3
$2
$1
1
2
3
4
5
6
Total Producer
Benefits
S
$6
$5
$4
$3
$2
$1
1
2
3
4
5
6
Producer
Surplus
S
$6
$5
$4
Producer
Costs
$3
$2
$1
1
2
3
4
5
6
Market Efficiency
Under
the assumptions of perfect
competition and no externalities, the
economic well-being of a society is
measured as the sum of consumer
surplus and producer surplus.
Market
Efficiency is attained when
total surplus is maximized, a point
where resource allocation is efficient.
Economic Well-Being and Total
Surplus
Consumer
Surplus
=
Value to _ Amount paid
buyers
by buyers
and
Producer
Surplus
=
Amount received _ Cost to
by sellers
sellers
Economic Well-Being and Total
Surplus
Total
Surplus
=
Consumer
Surplus
+
Producer
Surplus
or
Total
Surplus
=
Value to _ Cost to
buyers
sellers
Market Efficiency
S
PE
D
Market Efficiency
Consumer
Surplus
S
PE
Producer
Surplus
D
Market Efficiency
In addition to market
efficiency, a social planner
might also care about equity –
the fairness of the distribution
of well-being among the
various buyers and sellers.
Market Efficiency: Three observations
Free
markets allocate the supply of
goods to the buyers who value them
most highly.
Free
markets allocate the demand for
goods to the sellers who can produce
them at least cost.
Free
markets produce the quantity of
goods that maximizes the sum of
consumer and producer surplus.
Market Efficiency: Invisible Hand
 In
a free market system the many buyers
and sellers are interested in their own
well-being, self-interest.
 As
market participants are motivated by
self-interest a process of coordination
and communication takes place so that
buyers and sellers are directed to the
most efficient outcome.
 As
if by an Invisible Hand, the free
market system reaches efficiency.
The Efficiency of the Equalibrium
Price
S
Value
to
Buyers
Cost
to
sellers
Cost
to
sellers
0
Equilibrium
Value to buyers is greater
than cost to sellers.
Value
to
Buyers
quantity
Value to buyers is less
than cost to sellers.
D
Quantity
Quick Quiz
 Draw
the supply and
demand for turkey.
 In
the equilibrium,
show the producer
and consumer
surplus.
 Explain
why
producing more turkey
will lower total
surplus.
Market Failure
If
a market system is not one of perfect
competition, control over prices leads
to Market Power.
–
The ability by one buyer or seller to
control market price.
Market
Power causes markets to be
inefficient, and thus fail.
Market Failure
If
a market system affects individuals
other than buyers and sellers of that
market, side-effects are created and
called Externalities.
–
Benefits or costs imposed on a third party
who is not the consumer or the producer.
Externalities
cause markets to be
inefficient, and thus fail.
Externalities
Externalities are created when a market
outcome affects individuals other than
buyers and sellers in that market.
Externalities cause welfare in a market
to depend on more than just the value
to the buyers and cost to the sellers.
When buyers and sellers do not take
externalities into account when deciding
how much to consume and produce, the
equilibrium in the market can be
Summary
Consumer
surplus measures the
benefit buyers get from
participating in a market.
Consumer surplus can be
computed by finding the area
below the demand curve and
above the price.
Summary
Producer
surplus measures the
benefit sellers get from
participating in a market.
Producer surplus can be
computed by finding the area
below the price and above the
supply curve.
Summary
 The
equilibrium of demand and
supply maximizes the sum of
consumer and producer surplus.
 This is as if the invisible hand of the
marketplace leads buyers and
sellers to allocate resources
efficiently.
 Markets do not allocate resources
efficiently in the presence of market
failures.
Summary
 An
allocation of resources that
maximizes the sum of consumer
and producer surplus is said to be
efficient.
 Policymakers are often concerned
with the efficiency, as well as the
equity, of economic outcomes.