WEEK 4 - Chapter 7: Consumers, Producers and the Efficiency of Markets Flashcards
What is welfare economics?
The study of how the allocation of resources affects economic wellbeing.
We begin by examining the benefits that buyers and sellers receive from engaging in market transactions. We then examine how society can make these benefits as large as possible. This analysis leads to a profound conclusion – in any market, the equilibrium of supply and demand maximises the total benefits received by all buyers and sellers combined.
What is willingness to pay?
The maximum amount that a buyer will pay for a good.
It measures how much that buyer values the good. Each buyer would be eager to buy the album at a price less than his willingness to pay, and he would refuse to buy the album at a price greater than his willingness to pay. At a price equal to his willingness to pay, the buyer would be indifferent about buying the good – if the price is exactly the same as the value he places on the album, he would be equally happy buying it or keeping his money.
What is consumer surplus?
A buyer’s willingness to pay minus the amount the buyer actually pays.
Consumer surplus measures the benefit to buyers of participating in a market.
Using the demand curve to measure consumer surplus.
Consumer surplus is closely related to the demand curve for a product.
The is the step graph.
If 0 people value a cake above $20, they won’t buy it. Therefore, the Demand line will be on top of the vertical axis when it reach $20. If 1 person values a cake at $20 then a horizontal line will go from the vertical axis to the coordinate (1,20).
If 2 people value a cake at $10 then the line will drop vertically to the point (1,10) before horizontally going to (2,10). Etc.
How a lower price measures consumer surplus.
Because buyers always want to pay less for the goods they buy, a lower price makes buyers of a good better off.
This increase in consumer surplus is composed of two parts. First, those buyers who were already buying Q1 of the good at the higher price P1 are better off because they now pay less. Second, some new buyers enter the market because they are now willing to buy the good at the lower price and some existing buyers may decide to buy more of the good at the lower price.
What does consumer surplus measure?
Our goal in developing the concept of consumer surplus is to make normative judgements about the desirability of market outcomes.
What is cost?
The value of everything a seller must give up to produce a good.
Each painter would be eager to sell their services at a price greater than their cost and each would refuse to sell their services at a price that is less than their cost.
At a price exactly equal to their cost, each painter would be indifferent about selling their services: each would be equally happy getting the job or using their time and energy for another purpose.
What is producer surplus?
The amount a seller is paid for a good minus the seller’s cost.
Using the supply curve to measure producer surplus.
Just as consumer surplus is closely related to the demand curve, producer surplus is closely related to the supply curve.
Step graph.
How a higher price raises producer surplus.
Sellers always want to receive a higher price for the goods they sell. This increases their welfare (producer surplus).
This increase in producer surplus has two parts. First, those sellers who were already selling Q1 of the good at the lower price P1 are better off because they now get more for what they sell.
Second, some existing sellers choose to sell more and some new sellers enter the market because they are now willing to produce the good at the higher price, resulting in an increase in the quantity supplied from Q1 to Q2.
Market efficiency and market failure stuff.
The equilibrium of supply and demand maximises the sum of consumer and producer surplus. That is, the invisible hand of the marketplace leads buyers and sellers to allocate resources efficiently.
However, Markets do not allocate resources efficiently in the presence of MARKET FAILURE such as market power or externalities.
Insights about market outcomes.
- Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay.
- Free markets allocate the demand for goods to the sellers who can produce them at lowest cost.
Thus, given the quantity produced and sold in a market equilibrium, the social planner cannot increase economic wellbeing by changing the allocation of consumption among buyers or the allocation of production among sellers. But can the social planner raise total economic wellbeing by increasing or decreasing the quantity of the good? The answer is no, as stated in this third insight about market outcomes:
- Free markets produce the quantity of goods that maximises the sum of consumer and producer surplus.
What is the benevolent social planner?
To evaluate market outcomes, we introduce into our analysis a new, hypothetical character, called the benevolent social planner. The benevolent social planner is an all-knowing, all-powerful, well-intentioned dictator. The planner wants to maximise the economic wellbeing of everyone in society.
What do you suppose this planner should do? Should he just leave buyers and sellers at the equilibrium that they reach naturally on their own? Or can he increase economic wellbeing by altering the market outcome in some way?
Consumer, producer and total surplus.
We define consumer surplus as:
Consumer surplus = Value to buyers - Amount paid by buyers
Similarly, we define producer surplus as:
Producer surplus = Amount received by sellers - Costs of sellers
When we add consumer and producer surplus together, we obtain:
Total surplus = Value to buyers - Amount paid by buyers + Amount received by sellers - Costs of sellers
The amount paid by buyers equals the amount received by sellers, so the middle two terms in this expression cancel each other. As a result, we can write total surplus as:
Total surplus = Value to buyers - Costs of sellers
