3

SUPPLY AND DEMAND II: MARKETS AND WELFARE

 Consumers,
Producers, and the
7
Efficiency of Markets

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 REVISITING THE MARKET
EQUILIBRIUM
?
• Do the equilibrium price and
quantity maximize the total
welfare of buyers and sellers?
•/

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 Welfare Economics
• Welfare economics is the study of how the
allocation of resources affects economic well-
being.

1. Buyers and sellers receive benefits from taking

part in the market.

2. The equilibrium in a market maximizes the

total welfare of buyers and sellers.
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 Welfare Economics

• Consumer surplus measures economic welfare

from the buyer’s side.

• Producer surplus measures economic

welfare from the seller’s side.

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 CONSUMER SURPLUS

• Willingness to pay is the maximum

amount that a buyer will pay for a good.

• It measures how much the buyer values the

good or service.

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 CONSUMER SURPLUS

1
• Calculation of Consumer surplus

• Consumer surplus is the buyer’s willingness to

pay for a good minus the amount the buyer
actually pays for it.
• Consumer surplus=
buyer’s willingness - amount the buyer
actually pays
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Table 1 Four Possible Buyers’ Willingness to Pay

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 CONSUMER SURPLUS

• The market demand curve depicts the

various quantities that buyers would
be willing and able to purchase at
different prices.

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The Demand Schedule and the
Demand Curve

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 Figure 1 The Demand Schedule and the Demand Curve

Price of
Album

$100 John’s willingness to pay

80 Paul’s willingness to pay

70 George’s willingness to pay

50 Ringo’s willingness to pay

Demand

0 1 2 3 4 Quantity of
Albums
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Figure 2 Measuring Consumer Surplus with the Demand
Curve

(a) Price = $80

Price of
Album

$100
John’s consumer surplus ($20)

80

70

50

Demand

0 1 2 3 4 Quantity of
Albums

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Figure 2 Measuring Consumer Surplus with the Demand
Curve

(b) Price = $70

Price of
Album
$100
John’s consumer surplus ($30)

80
Paul’s consumer
70 surplus ($10)

Total
50 consumer
surplus ($40)

Demand

0 1 2 3 4 Quantity of
Albums

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Using the Demand Curve to Measure
Consumer Surplus

• The area below the demand

curve and above the price
measures the consumer
surplus in the market.

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Figure 3 How the Price Affects Consumer Surplus

(a) Consumer Surplus at Price P

Price
A
The area below
the demand
curve and
above the price
Consumer measures the
surplus
consumer
P1 surplus in the
B C
market.

Demand

0 Q1 Quantity

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HOW A LOWER PRICE RAISES
CONSUMER SURPLUS

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Figure 3 How the Price Affects Consumer Surplus

(b) Consumer Surplus at Price P

Price
A

Initial
consumer
surplus
C Consumer surplus
P1
B to new consumers

F
P2
D E
Additional consumer Demand
surplus to initial
consumers
0 Q1 Q2 Quantity

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What Does Consumer Surplus Measure?

2
• 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.

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 PRODUCER SURPLUS
• Producer surplus is the amount a seller is paid
for a good minus the seller’s cost.
• It measures the benefit to sellers participating in
a market.

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Table 2 The Costs of Four Possible Sellers

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Using the Supply Curve to Measure Producer
Surplus

Just as consumer surplus is

related to the demand curve,
producer surplus is closely
related to the supply curve.

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The Supply Schedule and the
Supply Curve

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Figure 4 The Supply Schedule and the Supply Curve
Using the Supply Curve to Measure Producer
Surplus

• The area below the price and

above the supply curve measures
the producer surplus in a
market.

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USING THE SUPPLY CURVE TO
MEASURE
PRODUCER SURPLUS

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Figure 5 Measuring Producer Surplus with the Supply
Curve

(a) Price = $600

Price of
House
Painting Supply The area below
the price and
above the
$900
supply curve
800
measures the
producer
600 surplus in a
500 market.
Grandma’s producer
surplus ($100)

0 1 2 3 4
Quantity of
Houses Painted
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Figure 5 Measuring Producer Surplus with the Supply
Curve

(b) Price = $800

Price of
House
Painting Supply
Total
producer
$900 surplus ($500)

800

600 Georgia’s producer

500 surplus ($200)

Grandma’s producer
surplus ($300)

0 1 2 3 4
Quantity of
Houses Painted
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Figure 6 How the Price Affects Producer Surplus

(a) Producer Surplus at Price P

Price
Supply

B
P1
C
Producer
surplus

0 Q1 Quantity
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HOW A HIGHER PRICE RAISES
PRODUCER SURPLUS

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Figure 6 How the Price Affects Producer Surplus

(b) Producer Surplus at Price P

Price
Additional producer Supply The area below
surplus to initial the price and
producers above the
supply curve
D E measures the
P2 F
producer
surplus in a
B
P1 market.
Initial C
Producer surplus
producer to new producers
surplus

0 Q1 Q2 Quantity
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 MARKET EFFICIENCY

• Efficiency is the property of a

resource allocation of
maximizing the total surplus
received by all members of
society.

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 MARKET EFFICIENCY
Consumer Surplus
= Value to buyers – Amount paid by buyers

and

Producer Surplus
= Amount received by sellers – Cost to sellers

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 MARKET EFFICIENCY
Total surplus
= Consumer surplus + Producer surplus

or

Total surplus
= Value to buyers – Cost to sellers

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EVALUATING THE MARKET
EQUILIBRIU

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 Is this equilibrium allocation of resources
efficient? Does it maximize total surplus?

To answer these questions, keep in mind that when a

market is in equilibrium, the price determines which buyers
and sellers participate in the market.

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 Figure 7 Consumer and Producer Surplus in the Market
Equilibrium
Price A Those buyers who value
the good more than the
price (represented by the
D segment AE on the
Supply demand curve) choose to
buy the good; those
buyers who value it less
Consumer than the price
surplus (represented by the
segment EB) do not.
Equilibrium E Similarly, those sellers
price
whose costs are less than
Producer the price (represented by
surplus the segment CE on the
supply curve) choose to
produce and sell the
Demand good; those sellers whose
B
costs are greater than the
price (represented by the
C segment ED)

0 Equilibrium Quantity
quantity
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 MARKET EFFICIENCY
• Three points Concerning Market Outcomes,
• Free markets allocate
1. the supply of goods to the buyers who value
them most highly, as measured by their
willingness to pay.
2. The demand for goods to the sellers who can
produce them at least cost.
3. Free markets produce the quantity of goods that
maximizes the sum of consumer and producer
surplus. To see why this is true, consider
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 Figure 8 The Efficiency of the Equilibrium Quantity

Price
Supply
At quantities less than
the equilibrium
quantity, the value to
buyers exceeds the
cost to sellers.
At quantities greater Value Cost
than the equilibrium to to
buyers sellers
quantity, the cost to
sellers exceeds the
value to buyers.
Therefore, the
market Cost Value
to to
equilibrium Demand
sellers buyers
maximizes the sum
of producer and 0 Equilibrium Quantity
consumer surplus. quantity
Consumers,
Producers, and the Value to buyers is greater Value to buyers is less
Efficiency of Markets than cost to sellers. than cost to sellers.

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 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.

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We can now better appreciate Adam
Smith’s invisible hand of the marketplace,

The social planner doesn’t need to alter the

market outcome because the invisible hand
has already guided buyers and sellers to an
allocation of the economy’s resources that
maximizes total surplus.

This conclusion explains why economists

often advocate free markets
as the best way to organize economic
activity.
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 Summary
• Consumer surplus equals buyers’ willingness to
pay for a good minus the amount they actually
pay for it.
• 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.

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 Summary
• Producer surplus equals the amount sellers
receive for their goods minus their costs of
production.
• 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.

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 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.

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 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.

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 Assignment
• Draw the supply and demand for turkey. In the
equilibrium, show producer and consumer surplus. Explain why
producing more turkey would lower total surplus
• Explain how buyers’ willingness to pay, consumer
surplus, and the demand curve are related.
• Explain how sellers’ costs, producer surplus, and the
supply curve are related.
• In a supply-and-demand diagram, show producer and
consumer surplus in the market equilibrium
• What is efficiency? Is it the only goal of economic
policymakers?

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• There are four consumers willing to pay the following amounts
for haircuts:
• Jerry: $7 Oprah: $2 Sally Jessy: $8 Montel: $5
• There are four haircutting businesses with the following
• costs:
• Firm A: $3 Firm B: $6 Firm C: $4 Firm D: $2
• Each firm has the capacity to produce only one haircut.

• For efficiency, how many haircuts should be given?

• Which businesses should cut hair, and which consumers
• should have their hair cut? How large is the maximum
• possible total surplus?
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• Ernie owns a water pump. Because pumping large
• amounts of water is harder than pumping small
• amounts, the cost of producing a bottle of water rises as
• he pumps more. Here is the cost he incurs to produce
• each bottle of water:
• Cost of first bottle $1 Cost of second bottle 3
• Cost of third bottle 5 Cost of fourth bottle 7
• a. From this information, derive Ernie’s supply schedule. Graph his supply
curve for bottled water.
• b. If the price of a bottle of water is $4, how many bottles does Ernie
produce and sell? How much producer surplus does Ernie get from these
sales? Show Ernie’s producer surplus in your graph.
• c. If the price rises to $6, how does quantity supplied change? How does
Ernie’s producer surplus change? Show these changes in your graph

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