Date post: | 22-Dec-2015 |
Category: |
Documents |
View: | 217 times |
Download: | 2 times |
3
SUPPLY AND DEMAND II: MARKETS AND WELFARE
7
Consumers, Producers, and the Efficiency of Markets
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 3
Revisiting The Market Equilibrium
• The theory of supply and demand shows how markets allocate scarce resources among competing needs.
• But are the equilibrium price and quantity the right price and the right quantity from society’s point of view?
• Do they maximize the total welfare of buyers and sellers?
• Whether the market allocation is desirable or not is the topic of welfare economics.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 4
Welfare Economics• Welfare economics is the study of how the
allocation of resources affects economic well-being
• It shows that:– Both buyers and sellers receive benefits from
taking part in the market– The equilibrium outcome—that we saw in
Chapter 4—maximizes the total welfare of buyers and sellers
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 5
Welfare Economics: two main concepts
• Consumer surplus measures economic welfare of the buyer.
• Producer surplus measures economic welfare of the seller.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 6
Willingness to pay
• To define consumer surplus we first need to define “willingness to pay.”
• Willingness to pay is the maximum amount that a buyer will pay for a good.
• It measures how much the buyer values the good.
Willingness to pay
• Assume there is a commodity such that every additional unit of it increases a consumer’s happiness by the same amount– In other words, the consumption of additional
units of this commodity induces neither boredom nor addiction
– Possible examples: potato chips? candy?
• Then the consumer’s willingness to pay for a product is an accurate measure of the happiness that he or she gets from it
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 7
Willingness to pay
• continuation from previous slide• If a bag of potato chips provides an unchanging
amount of happiness, and • if your willingness to pay is
– 4 bags of potato chips for a shirt and – 2 bags for a cup of coffee, then – one can safely say that the shirt makes you twice as happy
as the cup of coffee– In other words, your willingness to pay for a commodity is
an accurate measure of how much you like that thing• For a given dollar price of a bag of potato chips, your
willingness to pay can also be expressed in dollars
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 8
Willingness to pay
• continuation from previous slide• For example,
– if you are willing to pay $15 for a particular shirt, and– if a bag of potato chips always gives you 3 “haps” of
happiness, and sells at the price of $0.50 each, then– the shirt gives you 90 “haps” of happiness.
• In other words, your willingness to pay for the shirt is – a monetary measure of the happiness you get from
the shirt, which is– proportional to the happiness you get from the shirt,
as measured in “haps”
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 9
Table 1 Four Possible Buyers’ Willingness to Pay
For a mint-condition recording of Elvis Presley’s first album
11
Consumer Surplus
• Consumer surplus is the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it.– Example: If the Elvis album’s price is $75…
Buyer Willingness to Pay
Consumer Surplus
Buy?
John 100 25 Yes
Paul 80 5 Yes
George 70 -5 No
Ringo 50 -25 No
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS12
Market Demand
• The market demand schedule/curve shows the various quantities that buyers would be willing and able to purchase at different prices. – Chapter 4
• We can use the willingness-to-pay numbers to calculate the quantities demanded at every price– That is, we can calculate the market demand
schedule/curve from the willingness-to-pay numbers
13
The Demand ScheduleBuyer Willingness
to Pay
John 100
Paul 80
George 70
Ringo 50
Figure 1 The Demand Curve
Copyright©2003 Southwestern/Thomson Learning
Price ofAlbum
0 Quantity ofAlbums
Demand
1 2 3 4
$100 John’s willingness to pay
80 Paul’s willingness to pay
70 George’s willingness to pay
50 Ringo’s willingness to pay
Buyer Willingness to Pay
John 100
Paul 80
George 70
Ringo 50
The height of the demand curve at any quantity shows the willingness to pay of whoever bought the last unit.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 15
Area of a Rectangle
Height
Width
Area = Width × Height
Figure 2 Measuring Consumer Surplus with the Demand Curve
(a) Price = $80.01
Price ofAlbum
50
70
80
0
$100
Demand
1 2 3 4 Quantity ofAlbums
John’s willingness to pay ($100)
Buyer Willingness to Pay
Consumer Surplus
Buy?
John 100 20 Yes
Paul 80 0 No
George 70 -10 No
Ringo 50 -30 No
1. The area under the demand curve measures the total willingness to pay for the quantity demanded.
2. It is also the maximum willingness to pay that could be generated from that quantity.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 17
The market and the planner
• Suppose the government has one copy of the Elvis album. The government’s goal is to give it to one of the four guys so as to generate the maximum happiness.
• Who will get the government’s copy?
• Obviously, John.• Lesson: The market does the
best that the government could have done
Price = $80
Buyer Willingness to Pay
John 100
Paul 80
George 70
Ringo 50
Figure 2 Measuring Consumer Surplus with the Demand Curve
(b) Price = $70.01Price of
Album
50
70
80
0
$100
Demand
1 2 3 4 Quantity ofAlbums
Buyer Willingness to Pay
Consumer Surplus
Buy?
John 100 30 Yes
Paul 80 10 Yes
George 70 0 No
Ringo 50 -20 No
John’s willingness to pay Paul’s willingness to pay
1. The area under the demand curve measures the total willingness to pay for the quantity demanded.
2. It is also the maximum willingness to pay that could be generated from that quantity.
Interpersonal comparability• We just saw
– that the total area under the demand curve is $180, and – that is also the total willingness to pay of John and Paul
• But can we say it is the total happiness of John and Paul?• Yes,
– if there is a commodity—say, a bag of potato chips—that provides an unchanging amount of happiness to the consumer, and
– if John’s happiness and Paul’s happiness are comparable, and– if both John and Paul get the same happiness from a bag of
potato chips• That’s a lot of if’s! • But we will make these simplifying assumption anyway
– Not just for John and Paul, but for everybody
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 19
Utilitarianism
• The idea that – the happiness of an individual can be measured
numerically,– the happiness of a group of people can be measured
numerically, – the happiness of a group of people is simply the sum
of the numbers representing the happiness of the individual members of the group, and that
– social policy should seek to maximize the total happiness of society,
– is called utilitarianism• The welfare analysis in this chapter takes
utilitarianism as its guiding philosophy
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 20
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 21
The market and the planner
• Suppose the government has two copies of the Elvis album. The government’s goal is to give them to two of the four guys so as to generate the maximum happiness.
• Who will get the government’s copies?
• Obviously, John and Paul.• The market does the best that
the government could have done
Price = $70
Buyer Willingness to Pay
John 100
Paul 80
George 70
Ringo 50
Willingness to Pay from the Demand Curve
Quantity
(a) Willingness to Pay at Price P
Price
0
Demand
P1
Q1
B
A
C
The area under the demand curve also measures the maximum willingness to pay that could be obtained from Q1 units
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 23
Using the demand curve to measure willingness to pay
• In general, the area under the demand curve up to the quantity demanded is a graphical measure of the total willingness to pay of the buyers.
• It is also the maximum willingness to pay that can be obtained from that quantity– That is, the government could not give away
that quantity in a way that generates higher willingness to pay.
Figure 3 How the Price Affects Consumer Surplus
Consumersurplus
Quantity
(a) Consumer Surplus at Price P
Price
0
Demand
P1
Q1
B
A
C
Total Payment
Consumer Surplus (ABC) + Total Payment (OBCQ1) = Willingness to Pay (OACQ1)
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 28
Using the Demand Curve to Measure Consumer Surplus
• In general, the area below the demand curve and above the price measures the consumer surplus.
Figure 3 How the Price Affects Consumer Surplus
Initialconsumer
surplus
Quantity
(b) Consumer Surplus at Price P
Price
0
Demand
A
BC
D EF
P1
Q1
P2
Q2
Consumer surplusto new consumers
Additional consumersurplus to initial consumers
Shifts in Demand
• We have seen that the demand curve can shift, for reasons such as– a change in tastes, and– a change in the prices of related goods
• See chapter 4
• Given that the demand for a product can shift as a result of a change in the price of a related good, does it make sense to say that the area under the demand curve measures the happiness consumers get from the product?
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 30
Shifts in Demand• Continued from the previous slide• Yes!
– Keep in mind that the area under the demand curve is a monetary measure of the happiness obtained by buyers
– The objective or psychological happiness obtained from a shirt may be unchanged even if the monetary willingness to pay for the shirt changes, perhaps because of a change in the price of a related good
• In an earlier slide, a bag of potato chips was assumed to always provide 3 “haps” of happiness, and sold at a price of $0.50. Consequently, consumers were wiling to pay $15 for a shirt that provided 90 “haps” of happiness.
• It follows that if the price of a bag of potato chips rises to $1, consumers would then be willing to pay $30 for the same shirt, leading to an upward shift in the demand curve for shirts.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 31
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 33
Producer Surplus
• Producer surplus is the amount a seller is paid for a good minus the seller’s cost.
• It measures the net benefit to sellers
• It is almost but not quite the same as profit.– We’ll discuss this later
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 34
Cost of production
• The cost of production is the market value of all resources used in production– By all, I do mean all. Even if some resources
used in production were obtained for free, their market value must be included in cost.
Table 2 The Cost of Painting a House for Four Possible Sellers
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 36
The Supply Schedule and the Supply Curve
Seller Cost ($)
Mary 900
Frida 800
Georgia 600
Grandma 500
Figure 4 The Supply Schedule and the Supply Curve
Seller Cost ($)
Mary 900
Frida 800
Georgia 600
Grandma 500
The height of the supply curve at any quantity shows the production cost to whoever produces the last unit.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 38
Producer Surplus
• Producer surplus is the amount a seller is paid minus the seller’s cost– Example: If the going price for getting a house painted
is $700 we get the following table.
Seller Cost ($) Producer Surplus
Sell?
Mary 900 -200 No
Frida 800 -100 No
Georgia 600 100 Yes
Grandma 500 200 Yes
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 39
Using the Supply Curve to Measure Producer Surplus• The area below the price and above the
supply curve measures the producer surplus.
Figure 5 Measuring Producer Surplus with the Supply Curve
Quantity ofHouses Painted
Price ofHouse
Painting
500
800
$900
0
600
1 2 3 4
(a) Price = $599.99
Supply
Grandma’s Cost ($500)
Seller Cost ($) Producer Surplus
Sell?
Mary 900 -300 No
Frida 800 -200 No
Georgia 600 0 No
Grandma 500 100 Yes
1. The area under the supply curve is the cost of the quantity supplied
2. It is also the lowest cost for that quantity
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 43
Is there a better alternative to the market system?
• If the government had to get one house painted, who would get the job?
• Grandma, of course, if the government had any sense.
• And that’s exactly what happens in the market outcome.
• The market achieves the best that the government could have achieved
Seller Cost ($)
Mary 900
Frida 800
Georgia 600
Grandma 500
Figure 5 Measuring Producer Surplus with the Supply Curve
Quantity ofHouses Painted
Price ofHouse
Painting
500
800
$900
0
600
1 2 3 4
(b) Price = $799.99
Supply
Seller Cost ($) Producer Surplus
Sell?
Mary 900 -100 No
Frida 800 0 No
Georgia 600 200 Yes
Grandma 500 300 Yes
Grandma’s costGeorgia’s cost
1. The area under the supply curve is the cost of the quantity supplied
2. It is also the lowest cost for that quantity
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 45
Is there a better alternative to the market system?
• If the government had to get two houses painted, who would get the job?
• Grandma and Georgia, of course.• And that’s exactly what happens
in the market outcome.• The market achieves the best
that the government could have achieved
Seller Cost ($)
Mary 900
Frida 800
Georgia 600
Grandma 500
Figure 6 How the Price Affects Producer Surplus
Producersurplus
Quantity
(a) Producer Surplus at Price P
Price
0
Supply
B
A
C
Q1
P1
Production Cost
Total Revenue (OBCQ1) =Production Cost (OACQ1) + Producer Surplus (ABC)
Figure 6 How the Price Affects Producer Surplus
Quantity
(b) Producer Surplus at Price P
Price
0
P1B
C
Supply
A
Initialproducersurplus
Q1
P2
Q2
Producer surplusto new producers
Additional producersurplus to initialproducers
D EF
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 49
MARKET EFFICIENCY
• Consumer surplus and producer surplus may be used to address the following questions:– Is our free market system a good way of
running our economy?– Could we design a better system?
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 50
MARKET EFFICIENCY
Consumer Surplus
= Value to buyers – Amount paid by buyers
and
Producer Surplus
= Amount received by sellers – Cost to sellers
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 51
MARKET EFFICIENCY
Total surplus
= Consumer surplus + Producer surplus
= Value to buyers – Amount paid by buyers
+ Amount received by sellers – Cost to sellers
= Value to buyers – Cost to sellers
MARKET EFFICIENCY
• In fact, we can go further and say that
• Total Surplus = maximum willingness to pay – minimum production cost
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 52
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 53
MARKET EFFICIENCY
• An economic outcome is efficient if there is no feasible way to make the total surplus any higher.
Figure 7 Consumer and Producer Surplus in the Market Equilibrium
Producersurplus
Consumersurplus
Price
0 Quantity
Equilibriumprice
Equilibriumquantity
Supply
Demand
A
C
B
D
E
Cost
Consumersurplus
Figure 7 Consumer and Producer Surplus in the Market Equilibrium
Producersurplus
Price
0 Quantity
Equilibriumprice
Equilibriumquantity
Supply
Demand
A
C
B
D
E
Total Value (or, willingness to pay)
Total Surplus
Cost (also, Minimum Cost)
Consumersurplus
The best feasible outcome
Producersurplus
Price
0 Quantity
Equilibriumprice
Equilibriumquantity
Supply
Demand
A
C
B
D
E
Total Value (also, Maximum Value)
Maximum Total Surplus
As long as we produce the equilibrium quantity, it would be impossible to increase the Total Surplus by reallocating production and consumption.
But is the equilibrium output the right output to produce?
Maximum Cost saved
The best feasible outcome
Price
0 Quantity
Equilibriumprice
Equilibriumquantity
Supply
Demand
A
C
B
D
E
Minimum WTP lost
Alternative
Society would be worse off if it produces less than the equilibrium quantity
Minimum Cost
The best feasible outcome
Price
0 Quantity
Equilibriumprice
Equilibriumquantity
Supply
Demand
A
C
B
D
E
Society would be worse off if it produces more than the equilibrium quantity
Maximum Value of extra output
Alternative
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 59
MARKET EFFICIENCY
• Three Insights Concerning Market Outcomes– Free markets allocate the goods produced to
the buyers who value them most highly, as measured by their willingness to pay.
– Free markets allocate production of goods to those who can produce them at least cost.
– Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.
Figure 8 The Efficiency of the Equilibrium Quantity
Quantity
Price
0
Supply
Demand
Costto
sellers
Costto
sellers
Valueto
buyers
Valueto
buyers
Value to buyers is greaterthan cost to sellers.
Value to buyers is lessthan cost to sellers.
Equilibriumquantity
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 62
The Invisible Hand
• We pursue our self-interest, not the social interest
• It is, therefore, natural to think that the free market would lead to chaos
• And yet, as we just saw, the free market outcome is unimprovable
• This idea was most famously proposed by Adam Smith (1723 – 1790), the father of modern economics.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 63
The Invisible Hand
• ...[E]very individual … neither intends to promote the public interest, nor knows how much he is promoting it. … [H]e intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.
• The Wealth of Nations, Adam Smith, 1776
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 64
Ticket Scalping
• Ticket scalping is often frowned upon and sometimes considered illegal– See http://en.wikipedia.org/wiki/Ticket_resale
• But a typical view among economists is that “consenting adults should be able to make economic trades when they think it is to their mutual advantage”
• Scalping increases the economy’s efficiency
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 65
Market for organs
• Should people be allowed to sell, say, their kidneys?
• The efficiency of the economy will increase.• What about fairness?
– Rich will buy the kidneys; the poor will not. But– Right now healthy people have extra kidneys
while the sick have none.– The sale of organs may be more acceptable if
organ purchases by the poor were paid for with taxpayers’ money so that rich and poor had equal access
WHEN MARKETS FAIL
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 66
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 67
However, markets can go wrong
• Market Power
• Externalities
• Fairness
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 68
MONOPOLY
• If a market system is not perfectly competitive, firms may have market power.– Market power is the ability to influence prices.– Market power can cause markets to be
inefficient because it keeps price and quantity from the equilibrium of supply and demand.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 69
EXTERNALITIES
• Externalities– are created when a market outcome affects
individuals other than buyers and sellers in that market.
– 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 inefficient.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 70
FAIRNESS
• 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.
• The free market economic system is efficient but not necessarily fair
Health Care: a big exception• In most advanced countries, government policies
regarding health care routinely disregard the idea that free markets are best
• In the United Kingdom, the government builds hospitals, hires doctors and nurses, buys pharmaceutical drugs, and provides medical care to all residents
• Patients get no bills; tax revenues are used to pay all costs
• Fees of private doctors are paid by the government• Performance indicators are high• Costs are low• There is virtually no clamor for privatization
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 71
Video: Scroogenomics
• Heard the one about the economist who gave cash as a Valentines Day gift?– Scrooge alert: Your holiday spending may res
ult in an economic loss by Paul Solman, PBS Newshour, December 23, 2013.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 72
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 73
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.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 74
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.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 75
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.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 76
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.