Principles of Economics Ch. 7

Chapter 7: Consumers, Producers, and the Efficiency of Markets

Welfare Economics: The study of how the allocation of resources affects economic well-being
- Answers questions about how to best organize economic activity

Willingness to pay

Willingness to pay: The maximum amount a buyer will pay for a good; represents what a buyer values a good at
Consider the following scenario where four people want to buy an album:

In an auction, the price would raise to 80$, and Taylor would buy it at 80$ or more (because Carrie is unwilling to pay more)
- Taylor’s consumer surplus is her willingness to pay minus the price she paid
- If there are two albums to sell, then both Taylor and Carrie receive a consumer surplus, and the total market consumer surplus rises

Using the Demand Curve to Measure Consumer Surplus

How a Lower Price Raises Consumer Surplus

At lower prices, the price of the good is lower than more consumers’ value of the good, thus leading to a higher consumer surpus
Graph:

What Does Consumer Surplus Measure?

Consumer surplus is a good measure of economic well-being from the perspective of the buyers, as they are getting good value
Consumer surplus can sometimes be ignored in a market; lowering the price of heroine is not good but would increase consumer surplus

Cost and the Willingness to Sell

Cost: The value of everything (resources, manpower, time) that a seller uses to produce a good, essentially equivalent to willingness to sell
Consider the following scenario where four sellers are competing to paint a house:

In an auction, the price would start high and quickly lower to 500$; Andy would offer a price of 600$ or slightly lower and take the job (because Pablo is unwilling to sell for lower than 600$)
- Andy’s consumer surplus is the price he sells his service at minus his cost of production
- If there are two houses to paint, then Pablo and Andy will both receive a producer surplus, and the total market producer surplus rises

Using the Supply Curve to Measure Producer Surplus

How a Higher Price Raises Producer Surplus

A higher price increases producer surplus because more producers get a higher profit margin for their service
Graph:

The Benevolent Social Planner

Consider a dictator who wants to maximize economic well-being in society
Can calculate total surplus in a market by adding consumer and producer surplus
- Total surplus = Value to buyers - Cost to sellers = Buyers’ willingness to pay - Sellers’ cost
An allocation of resources that maximizes total surplus exhibits **efficiency**
- Inefficient allocations include ones where producers are, wastefully, having higher costs to produce or ones where goods aren’t consumed by buyers who value them the most
Equality: Whether buyers and sellers both have similar levels of economics well-being
Thinking of the market as a pie, efficiency attempts to make the pie as big as possible while equality attempts to split it evenly

Evaluating the Market Equilibrium

At the equilibrium, the buyers who value the good the most and the sellers who have the lowest cost both consume/produce the good; therefore, the market equilibrium represents the greatest total surplus
- Graph:
Free markets also naturally produce the quantity of goods which maximize total surplus; reducing the quantity creates a shortage, while increasing the quantity creates a surplus
- Graph:
The benevolent dictator need not intervene; the invisible hand of the market will do everything for them