consumers, producers, and the efficiency of markets

Principles of Economics
Session V

Consumers, Producers,
and the Efficiency of Markets
Overview
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?
1
Learning Objectives
By the end of this session, students should
understand:
–the link between buyers’ willingness to pay for a
good and the demand curve.
–how to define and measure consumer surplus.
–the link between sellers’ costs of producing a good
and the supply curve.
–how to define and measure producer surplus.
–that the equilibrium of supply and demand
maximizes total surplus in a market.

2
3
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
Part I
Willingness to Pay (WTP)
and Consumer Surplus
Consumers, Producers and the
Efficiency of the Market
5
Willingness to Pay (WTP)
A buyer’s willingness to pay for a good: the maximum
amount the buyer will pay for that good.
WTP measures how much the buyer values the good.
name WTP
John $250
Paul 175
George 300
Ringo 125
Example:
4 buyers’ Willingness-to-Pay
for an iPod
Source: Mankiw (2011)
6
WTP and the Demand Curve
Q: If price of iPod is $200, who will buy an iPod, and
what is quantity demanded?
A: John & George will buy an iPod,
Paul & Ringo will not.
Hence, Q
d

= 2
when P = $200.
name WTP
John $250
Paul 175
George 300
Ringo 125
7
WTP and the Demand Curve
Derive the demand schedule of iPod:
4
George, John,
Paul, Ringo
0 – 125
3
George, John,
Paul
126 – 175
2 George, John 176 – 250
1 George 251 – 300
0 nobody $301 & up
Q
d
who buys P (price)
name WTP
John $250
Paul 175
George 300
Ringo 125
8

WTP and the Demand Curve
$0
$50
$100
$150
$200
$250
$300
$350
0 1 2 3 4
P Q
d
$301 & up 0
251 – 300 1
176 – 250 2
126 – 175 3
0 – 125 4
P
Q
9
About the Staircase Shape…
$0
$50
$100
$150
$200
$250
$300
$350
0 1 2 3 4

P
Q

10
WTP and the Demand Curve
At any Q,
the height of
the D curve is
the WTP of the
marginal buyer
$0
$50
$100
$150
$200
$250
$300
$350
0 1 2 3 4
P
Q
George’s WTP
John’s WTP
Paul’s WTP
Ringo’s
WTP
11
Consumer Surplus (CS)
Consumer surplus : the amount a buyer is willing to
pay minus the amount the buyer actually pays:

CS = WTP – P
name WTP
John $250
Paul 175
George 300
Ringo 125
Suppose P = $260.
George’s CS = $300 – 260 = $40.
The others get no CS because they do
not buy an iPod at this price.
Total CS = $40.
12
CS and the Demand Curve
$0
$50
$100
$150
$200
$250
$300
$350
0 1 2 3 4
P
Q
George’s WTP
P = $260
George’s CS =
$300 – 260 = $40
Total CS = $40
13

CS and the Demand Curve
$0
$50
$100
$150
$200
$250
$300
$350
0 1 2 3 4
P
Q
George’s WTP
John’s WTP
Instead, suppose
P = $220
George’s CS =
$300 – 220 = $80
John’s CS =
$250 – 220 = $30
Total CS = $110
14
CS with Lots of Buyers & a Smooth
Demand Curve
0
10
20
30
40
50

60
0 5 10 15 20 25 30
P
Q
$
The demand for shoes
D
1000s of pairs
of shoes
Price
per pair
Source: Mankiw (2011)
15
CS with Lots of Buyers & a Smooth
Demand Curve
CS = ½ x 15 x $30
= $225.
0
10
20
30
40
50
60
0 5 10 15 20 25 30
P
Q
The demand for shoes
D
h

$
16
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.
0
10
20
30
40
50
60
0 5 10 15 20 25 30
P
Q
D
1. Fall in CS
due to buyers
leaving the market
2. Fall in CS due to
remaining buyers
paying higher P
17
0
5
10
15

20
25
30
35
40
45
50
0 5 10 15 20 25
P
Q
demand curve
A. Find marginal
buyer’s WTP at
Q = 10.
B. Find CS for
P = $30.
Suppose P falls to $20.
How much will CS increase
due to…
C. buyers entering
the market
D. existing buyers paying
lower price
$
Exercise V-1: Consumer Surplus
Part II
Cost, Supply Curve and
Producer Surplus
Consumers, Producers and the
Efficiency of the Market

20
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 cost of all resources used to produce good,
including value of the seller’s time.
Example: Costs of 3 sellers in the lawn-cutting business.
name cost
Jack $10
Janet 20
Chrissy 35
A seller will produce and sell the
good/service only if the
price exceeds his or her cost.
Hence, cost is a measure of
willingness to sell.
21
Cost and the Supply Curve
Derive the supply schedule from the cost data:

3 35 & up
2 20 – 34
1 10 – 19
0 $0 – 9
Q
s
P
name cost
Jack $10
Janet 20

Chrissy 35
22
Cost and the Supply Curve
$0
$10
$20
$30
$40
0 1 2 3
P
Q
P Q
s
$0 – 9 0
10 – 19 1
20 – 34 2
35 & up 3
23
Cost and the Supply Curve
$0
$10
$20
$30
$40
0 1 2 3
P
Q
At each Q, the
height of the S curve
is the cost of the

marginal seller
Chrissy’s
cost
Janet’s
cost
Jack’s cost
24
Producer Surplus
$0
$10
$20
$30
$40
0 1 2 3
P
Q
Producer surplus (PS):
the amount a seller
is paid for a good
minus the seller’s cost
PS = P – cost
Source: Mankiw (2011)
25
Producer Surplus and the Supply
Curve
$0
$10
$20
$30
$40

0 1 2 3
P
Q
PS = P – cost
Suppose P = $25.
Jack’s PS = $15
Janet’s PS = $5
Chrissy’s PS = $0
Total PS = $20
Janet’s
cost
Jack’s cost
Total PS equals the
area above the supply
curve under the price,
from 0 to Q.
Chrissy’s
cost