In this chapter, look for the answers to

Lecture 7
these questions:
What is consumer surplus? How is it related to
Consumers, Producers, and the the demand curve?
Efficiency of Markets 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?

Welfare Economics Willingness to Pay (WTP)

Recall, the allocation of resources refers to: A buyers willingness to pay for a good is the
how much of each good is produced maximum amount the buyer will pay for that good.
which producers produce it WTP measures how much the buyer values the
good.
which consumers consume it
Welfare economics: name WTP Example:
the study of how the allocation of resources 4 buyers WTP
Ana $250
affects economic well-being for an iPod
Maria 175
First, we look at the well-being of consumers. Sara 300
Mina 125

2 3

WTP and the Demand Curve WTP and the Demand Curve
Q: If price of iPod is $200, who will buy an iPod, Derive the
and what is quantity demanded? P (price
demand who buys Qd
of iPod)
schedule:
A: Ana & Sara will buy an iPod, $301 & up nobody 0
Maria & Mina will not.
name WTP name WTP 251 300 Sara 1
Hence, Qd = 2
Ana $250 when P = $200. Ana $250 176 250 Ana, Sara 2
Maria 175 Maria 175 Maria, Ana,
126 175 3
Sara 300 Sara 300 Sara
Mina, Maria,
Mina 125 Mina 125 0 125 4
Ana, Sara

4 5

1
 WTP and the Demand Curve About the Staircase Shape
P $350 P This D curve looks like a staircase
$350 $300 with 4 steps one per buyer.
P Qd
$300 $250 If there were a huge # of buyers,
$301 & up 0 as in a competitive market,
$250
$200 there would be a huge #
$200 251 300 1
$150 of very tiny steps,
$150 176 250 2 and it would look
$100
$100 more like a smooth
126 175 3 $50 curve.
$50
0 125 4 $0
$0 Q Q
0 1 2 3 4 0 1 2 3 4
6 7

WTP and the Demand Curve Consumer Surplus (CS)

P At any Q, Consumer surplus is the amount a buyer is willing
Saras WTP
$350 the height of to pay minus the buyer actually pays:
$300 Anas WTP the D curve is
CS = WTP P
$250 the WTP of the
Marias WTP marginal buyer,
$200 Minas
the buyer who name WTP Suppose P = $260.
WTP
$150 would leave the
Ana $250 Saras CS = $300 260 = $40.
$100 market if P were
The others get no CS because
any higher. Maria 175
$50 they do not buy an iPod at this
Sara 300 price.
$0
Q Mina 125 Total CS = $40.
0 1 2 3 4
8 9

CS and the Demand Curve CS and the Demand Curve

P P
Saras WTP P = $260 Saras WTP Instead, suppose
$350 $350 P = $220
Saras CS = Anas WTP
$300 $300 260 = $40 $300 Saras CS =
$250 Total CS = $40 $250 $300 220 = $80
$200 $200 Anas CS =
$250 220 = $30
$150 $150
Total CS = $110
$100 $100
$50 $50
$0 Q $0 Q
0 1 2 3 4 0 1 2 3 4
10 11

2
 CS and the Demand Curve CS with Lots of Buyers & a Smooth D Curve
P At Q = Price The demand for shoes
$350 The lesson: per P
5(thousand), the pair
Total CS equals $ 60
$300 marginal buyer is
the area under willing to pay $50 50
$250 the demand curve for pair of shoes.
above the price, 40
$200
from 0 to Q. Suppose P = $30.
30
$150 1000s of pairs
Then his
20 of shoes
$100 consumer surplus
= $20. 10
$50 D
$0 0 Q
Q
0 5 10 15 20 25 30
0 1 2 3 4
12 13

CS with Lots of Buyers & a Smooth D Curve How a Higher Price Reduces CS
CS is the area b/w The demand for shoes If P rises to $40,
P and the D curve, P P
CS = x 10 x $20 1. Fall in CS
from 0 to Q. $ 60 60
due to buyers
= $100.
Recall: area of 50 50 leaving market
Two reasons for the
a triangle equals h
40 fall in CS. 40
x base x height
Height of 30 30
this triangle is 20 20
2. Fall in CS due to
$60 30 = $30.
10 remaining buyers 10
So, D paying higher P D
CS = x 15 x $30 0 Q 0 Q
= $225. 0 5 10 15 20 25 30 0 5 10 15 20 25 30
14 15

A C T I V E L E A R N I N G 1: A C T I V E L E A R N I N G 1:
demand curve demand curve
Consumer surplus 50
P Answers P
50
A. Find marginal $ 45 $ 45
A. At Q = 10, marginal
buyers WTP at 40 buyers WTP is $30. 40
Q = 10. 35 35
B. CS = x 10 x $10
B. Find CS for 30 = $50 30
P = $30. 25 25
P falls to $20.
Suppose P falls to $20. 20 20
How much will CS 15 C. CS for the 15
increase due to additional buyers
10 10
C. buyers entering = x 10 x $10 = $50
5 5
the market D. Increase in CS
0 0
D. existing buyers on initial 10 units
0 5 10 15 20 Q
25 0 5 10 15 20 Q
25
paying lower price = 10 x $10 = $100
16 17

3
 Cost and the Supply Curve Cost and the Supply Curve
Cost is the value of everything a seller must give
up to produce a good (i.e., opportunity cost). P Qs
Includes cost of all resources used to produce Derive the supply schedule
$0 9 0
good, including value of the sellers time. from the cost data:
Example: Costs of 3 sellers in the lawn-cutting 10 19 1
business.
20 34 2
name cost A seller will only produce and name cost
sell the good if the price 35 & up 3
Pablo $10 exceeds his or her cost. Pablo $10
Pedro 20 Pedro 20
Hence, cost is a measure of
Juan 35 willingness to sell. Juan 35
18 19

Cost and the Supply Curve Cost and the Supply Curve
P P At each Q, the
$40 P Qs $40 height of the S curve
Juans
cost is the cost of the
$0 9 0
$30 $30 marginal seller,
10 19 1 Pedros
the seller who would
$20 $20 cost leave the market if
20 34 2 the price were any
$10 35 & up 3 $10 Pablos cost lower.

$0 Q $0 Q
0 1 2 3 0 1 2 3
20 21

Producer Surplus Producer Surplus and the S Curve

P PS = P cost P PS = P cost
$40 Producer surplus (PS): $40 Juans Suppose P = $25.
the amount a seller cost
Pablos PS = $15
$30 is paid for a good $30
minus the sellers cost. Pedros Pedros PS = $5
$20 $20 cost
Juans PS = $0

$10 $10 Pablos cost Total PS = $20

Total PS equals the

$0 Q $0 Q area above the supply
0 1 2 3 0 1 2 3 curve under the price,
from 0 to Q.
22 23

4
PS with Lots of Sellers & a Smooth S Curve PS with Lots of Sellers & a Smooth S Curve
Suppose P = Price The supply of shoes PS is the area b/w The supply of shoes
P P
$40. per 60 P and the S curve,
from 0 to Q. 60
At Q = pair
50 S 50 S
15(thousand), The height of this
the marginal 40 triangle is 40
sellers cost is $40 15 = $25.
30 30
$30, 1000s of pairs So, h
20 of shoes 20
and her PS = x b x h
producer 10 = x 25 x $25 10
surplus is $10. 0 Q = $312.5 0 Q
0 5 10 15 20 25 30 0 5 10 15 20 25 30
24 25

How a Lower Price Reduces PS A C T I V E L E A R N I N G 2:

supply curve
Producer Surplus P
50
If P falls to $30, P A. Find marginal
1. Fall in PS 45
PS = x 15 x $15 60 due to sellers sellers cost 40
= $112.5 leaving market at Q = 10. 35
50 S
B. Find PS for 30
Two reasons for 40 P = $20. 25
the fall in PS.
30 Suppose P rises to $30. 20
Find the increase
2. Fall in PS due to 20 15
in PS due to
remaining sellers 10 10
getting lower P C. selling 5
5
0 Q additional units
0
0 5 10 15 20 25 30 D. getting a higher price Q
0 5 10 15 20 25
on the initial 10 units
26 27

A C T I V E L E A R N I N G 2: What do CS, PS, and Total Surplus Measure?

supply curve
Answers P
50
A. At Q = 10, 45 CS = (value to buyers) (amount paid by buyers)
marginal cost = $20 40 CS measures the benefit buyers receive
B. PS = x 10 x $20 35 from participating in the market.
= $100 30
PS = (amount received by sellers) (cost to sellers)
P rises to $30. 25
PS measures the benefit sellers receive
20
C. PS on from participating in the market.
15
additional units
= x 5 x $10 = $25 10 Total surplus = CS + PS
5 TS measures the total gains from trade in a market.
D. Increase in PS
0
on initial 10 units
0 5 10 15 20 Q
25
= 10 x $10 = $100
28 29

5
 The Markets 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 markets allocation of resources desirable?
Or would a different allocation of resources make
society better off?
Measuring Societys 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)

To answer this, we use total surplus as a

measure of societys well-being.

30 31

Efficiency
Total
= (value to buyers) (cost to sellers)
surplus
An allocation of resources is efficient if it maximizes
total surplus. Efficiency means:
Raising or lowering the quantity of a good
would not increase total surplus.
The goods are being produced by the producers
with lowest cost.
The goods are being consumed by the buyers
who value them most highly.
Efficiency
Total
= (value to buyers) (cost to sellers)
surplus
Efficiency means making the pie as big as
possible.
In contrast, equity refers to whether the pie is
divided fairly.
Whats fair is subjective, harder to evaluate.
Hence, we focus on efficiency as the goal,
even though policymakers in the real world
usually care about equity, too.

32 33

Evaluating the Market Equilibrium Which Buyers Get to Consume the Good?
Market eqm: Every buyer
P P
P = $30 whose WTP is
60 60
Q = 15,000 $30 will buy.
50 S 50 S
Total surplus Every buyer
= CS + PS 40 CS whose WTP is 40
Is the market eqm 30 < $30 will not. 30
efficient? PS
20 So, the buyers who 20
value the good most
10 10
D highly are the ones D
0 Q who consume it. 0 Q
0 5 10 15 20 25 30 0 5 10 15 20 25 30
34 35

6
 Which Sellers Produce the Good? Does Eqm Q Maximize Total Surplus?
Every seller whose At Q = 20,
P P
cost is $30 will cost of producing
60 the marginal unit 60
produce the good.
50 S is $35 50 S
Every seller whose
40 value to consumers 40
cost is > $30 will
of the marginal unit
not.
30 is only $20 30
Hence, the sellers Hence, can increase
20 20
with the lowest cost total surplus
produce the good. 10 10
D by reducing Q. D
0 Q This is true at any Q 0 Q
0 5 10 15 20 25 30 greater than 15. 0 5 10 15 20 25 30
36 37

Does Eqm Q Maximize Total Surplus? Evaluating the Market Eqm: Summary
At Q = 10,
P The market eqm is efficient:
cost of producing
60 The eqm Q maximizes total surplus.
the marginal unit
is $25 50 S The goods are produced by the producers with
lowest cost,
value to consumers 40
of the marginal unit and consumed by the buyers who value them
is $40 30 most highly.
Hence, can increase 20 The govt cannot improve on the market outcome.
total surplus
10 Laissez faire (French for allow them to do):
by increasing Q. D
This is true at any Q 0 Q the govt should not interfere with the market.
less than 15. 0 5 10 15 20 25 30
38 39

Why Non-Market Allocations Are Usually Bad CONCLUSION

Suppose the allocation of resources were instead
determined by a central planner (e.g., the
Communist leaders of the former Soviet Union.)
To choose an efficient allocation, the planner
would need to know every sellers cost
and every buyers WTP, for each of the
thousands of goods produced in the economy.
This is practically impossible, so centrally planned
economies are never very efficient.
40
This chapter used welfare economics to
demonstrate one of the Ten Principles:
Markets are usually a good way to
organize economic activity.
But we assumed markets are perfectly competitive.
In the real world, sometimes there are
market failures, when unregulated markets fail to
allocate resources efficiently. Causes:
market power a single buyer or seller can
influence the market price, e.g. monopoly
externalities side effects of transactions,
e.g. pollution
41

7
 CONCLUSION The Effects of a Tax
When markets fail, public policy may remedy the With no tax, P
problem and increase efficiency. eqm price is PE
and quantity is QE . Size of tax = PT
Welfare economics sheds light on market
failures and govt policies. Govt imposes a PB S
tax of PT per
Despite the possibility of market failure, unit.
The price buyers
PE
the assumptions in this chapter work well in pay is PB , PS D
many markets, and the invisible hand remains
the price sellers
extremely important.
receive is PS ,
and quantity is QT . Q
QT QE

42 43

The Effects of a Tax The Effects of a Tax

P Next, we use the tools of welfare economics to
The tax generates measure the gains and losses from a tax.
revenue equal to
Size of tax = PT
PT x Q T . We will determine consumer surplus (CS),
PB S producer surplus (PS), tax revenue, and total
PE surplus with and without the tax.

PS D
Tax revenue is included in total surplus,
because tax revenue can be used to provide
services such as roads, police, public education,
etc.
Q
QT QE

44 45

The Effects of a Tax The Effects of a Tax

Without a tax, P With the tax, P

CS = A + B + C CS = A
PS = D + E + F PS = F
A A
Tax revenue = 0 S Tax revenue PB S
B C =B+D B C
Total surplus PE
= CS + PS D E Total surplus D E
D =A+ B PS D
=A+ B + C
F +D+F F
+D+E+F
The tax causes
total surplus to
Q Q
QT QE fall by C + E QT QE

46 47

8
 The Effects of a Tax About the Deadweight Loss
P Because of the tax, P
C + E is called the the units between
deadweight loss QT and QE are not
(DWL) of the tax, A sold.
PB S PB S
the fall in total
B The value of these
surplus that C
units to buyers is
results from a D E
greater than the cost
market distortion, PS D PS D
of producing them,
such as a tax. F
so the tax has
prevented some
Q mutually beneficial Q
QT QE QT QE
trades.
48 49

A C T I V E L E A R N I N G 3: A C T I V E L E A R N I N G 3:
The market for The market for
Analysis of tax Answers to A
P airplane tickets P airplane tickets
A. Compute P400 CS $ 400
CS, PS, and 350 = x $200 x 100 350
total surplus 300 = $10,000 300
without a tax. S S
250 PS 250
B. If P100 tax = x $200 x 100 P = 200
200
per ticket, = $10,000
150 150
compute D D
CS, PS, 100 total surplus 100
tax revenue, 50 = $10,000 + $10,000 50
total surplus, 0 Q = $20,000 0 Q
and DWL.
0 25 50 75 100 125 0 25 50 75 100 125
50 51

A C T I V E L E A R N I N G 3:
What Determines the Size of the DWL?
Answers to B A $100 tax on
P airplane tickets The govt needs tax revenue to finance roads,
CS $ 400
schools, police, etc., so it must tax some goods
= x $150 x 75 350 and services.
= $5,625
300
S
Which ones? One answer is that govt should tax
PS = $5,625 PB = 250 the goods or services with the smallest DWL.
tax revenue 200 So when is the DWL small vs. large? Turns out it
= $100 x 75 PS = 150 depends on the elasticities of supply and demand.
= $7,500 D
100 Recall: The price elasticity of demand (or supply)
total surplus 50 measures how much quantity demanded
= $18,750 (or supplied) changes when the price changes.
0 Q
DWL = $1,250
0 25 50 75 100 125
52 53

9
 Why Elasticity Affects the Size of DWL
CHAPTER SUMMARY
A tax distorts the market outcome:
consumers buy less and producers sell less, The height of the D curve reflects the value of the
so eqm Q is below the surplus-maximizing good to buyerstheir willingness to pay for it.
quantity. Consumer surplus is the difference between what
buyers are willing to pay for a good and what they
Elasticity measures how much buyers and actually pay.
sellers respond to changes in price,
and therefore determines how much the
On the graph, consumer surplus is the area
between P and the D curve.
tax distorts the market outcome.

54 55

CHAPTER SUMMARY CHAPTER SUMMARY

The height of the S curve is sellers cost of
producing the good. Sellers are willing to sell if
the price they get is at least as high as their cost.
Producer surplus is the difference between what
sellers receive for a good and their cost of
producing it.
On the graph, producer surplus is the area
between P and the S curve.
To measure of societys well-being, we use
total surplus, the sum of consumer and producer
surplus.
Efficiency means that total surplus is maximized,
that the goods are produced by sellers with lowest
cost, and that they are consumed by buyers who
most value them.
Under perfect competition, the market outcome is
efficient. Altering it would reduce total surplus.

56 57

CHAPTER SUMMARY
A tax on a good reduces the welfare of buyers and
sellers. This welfare loss usually exceeds the revenue
the tax raises for the govt.
The fall in total surplus (consumer surplus, producer
surplus, and tax revenue) is called the deadweight loss
(DWL) of the tax.
A tax has a DWL because it causes consumers to buy
less and producers to sell less, thus shrinking the market
below the level that maximizes total surplus.
The price elasticities of demand and supply measure
how much buyers and sellers respond to price changes.
Therefore, higher elasticities imply higher DWLs.

58

10