Consumers, Producers, and the In this chapter, look for the answers to

7 Efficiency of Markets these questions:

ƒ What is consumer surplus? How is it related to
PRINCIPLES OF the demand curve?

MICROECONOMICS ƒ What is producer surplus? How is it related to the

supply curve?
FOURTH EDITION
ƒ Do markets produce a desirable allocation of
N. G R E G O R Y M A N K I W resources? Or could the market outcome be
improved upon?
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© 2008 Thomson South-Western, all rights reserved CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 1

Welfare Economics Willingness to Pay (WTP)

ƒ Recall, the allocation of resources refers to: A buyer’s 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
ƒ Welfare economics studies how the allocation name WTP Example:
of resources affects economic well-being. 4 buyers’ WTP
Anthony $250
for an iPod
ƒ First, we look at the well-being of consumers. Chad 175
Flea 300
John 125

CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 2 CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 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: Anthony & Flea will buy an iPod, $301 & up nobody 0
Chad & John will not.
name WTP name WTP 251 – 300 Flea 1
Hence, Qd = 2
Anthony $250 when P = $200. Anthony $250 176 – 250 Anthony, Flea 2
Chad 175 Chad 175 Chad, Anthony,
126 – 175 3
Flea 300 Flea 300 Flea
John, Chad,
John 125 John 125 0 – 125 4
Anthony, Flea

CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 4 CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 5

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

WTP and the Demand Curve Consumer Surplus (CS)

P At any Q, Consumer surplus is the amount a buyer is willing
Flea’s WTP
$350 the height of to pay minus the amount the buyer actually pays:
$300 Anthony’s WTP the D curve is
CS = WTP – P
the WTP of the
$250 Chad’s WTP marginal buyer,
John’s Suppose P = $260.
$200 the buyer who name WTP
WTP
$150 would leave the Flea’s CS = $300 – 260 = $40.
Anthony $250
market if P were
$100 The others get no CS because
any higher. Chad 175
they do not buy an iPod at this
$50 Flea 300 price.
$0 Q John 125 Total CS = $40.
0 1 2 3 4
CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 8 CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 9

CS and the Demand Curve CS and the Demand Curve

P P
Flea’s WTP P = $260 Flea’s WTP Instead, suppose
$350 $350 P = $220
Flea’s CS =
$300 $300 Anthony’s WTP
$300 – 260 = $40 Flea’s CS =
$250 Total CS = $40 $250 $300 – 220 = $80
$200 $200 Anthony’s 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
CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 10 CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 11

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

$50 10
D
$0 0 Q
Q
0 5 10 15 20 25 30
0 1 2 3 4
CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 12 CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 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 P
P and the D curve, CS = ½ x 10 x $20 1. Fall in CS
from 0 to Q. $ 60 60
= $100. due to buyers
50 50 leaving market
Recall: area of h Two reasons for the
a triangle equals 40 fall in CS. 40
½ x base x height
30 30
Height =
20 2. Fall in CS due to 20
$60 – 30 = $30.
10 remaining buyers 10
So, D paying higher P D
CS = ½ x 15 x $30 0 Q 0 Q
= $225. 0 5 10 15 20 25 30 0 5 10 15 20 25 30
CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 14 CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 15

ACTIVE LEARNING 1: Cost and the Supply Curve

demand curve
Consumer surplus 50
P
$ 45
ƒ Cost is the value of everything a seller must give
A. Find marginal up to produce a good (i.e., opportunity cost).
buyer’s WTP at 40
Q = 10. ƒ Includes cost of all resources used to produce
35 good, including value of the seller’s time.
B. Find CS for 30
P = $30. 25
ƒ Example: Costs of 3 sellers in the lawn-cutting
Suppose P falls to $20. 20 business.
How much will CS name cost A seller will only produce and
15
increase due to… sell the good if the price
10 Angelo $10
C. buyers entering exceeds his or her cost.
5
the market Hunter 20
0 Hence, cost is a measure of
D. existing buyers Q Kitty 35 willingness to sell.
0 5 10 15 20 25
paying lower price
16 CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 17

3
 Cost and the Supply Curve Cost and the Supply Curve
P
P Qs $40 P Qs
Derive the supply schedule
from the cost data: $0 – 9 0 $0 – 9 0
$30
10 – 19 1 10 – 19 1
$20
20 – 34 2 20 – 34 2
name cost
35 & up 3 $10 35 & up 3
Angelo $10
Hunter 20 $0 Q
Kitty 35 0 1 2 3
CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 18 CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 19

Cost and the Supply Curve Producer Surplus

P At each Q, the P PS = P – cost
$40 height of the S curve $40 Producer surplus (PS):
Kitty’s
cost is the cost of the the amount a seller
$30 marginal seller, $30 is paid for a good
the seller who would minus the seller’s cost.
Hunter’s
$20 cost leave the market if $20
the price were any
$10 Angelo’s cost lower. $10

$0 Q $0 Q
0 1 2 3 0 1 2 3
CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 20 CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 21

Producer Surplus and the S Curve PS with Lots of Sellers & a Smooth S Curve
P PS = P – cost Suppose P = $40.
Price P The supply of shoes
$40 per pair
At Q = 15(thousand),
Kitty’s Suppose P = $25. 60
cost the marginal seller’s S
Angelo’s PS = $15 50
$30 cost is $30,
Hunter’s PS = $5 40
Hunter’s and her producer
$20 cost surplus is $10. 30
Kitty’s PS = $0
1000s of pairs
Total PS = $20 20 of shoes
$10 Angelo’s cost
10
Total PS equals the
$0 Q area above the supply 0 Q
0 1 2 3 curve under the price, 0 5 10 15 20 25 30
from 0 to Q.
CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 22 CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 23

4
PS with Lots of Sellers & a Smooth S Curve How a Lower Price Reduces PS
PS is the area b/w The supply of shoes If P falls to $30,
P P 1. Fall in PS
P and the S curve,
from 0 to Q. 60 PS = ½ x 15 x $15 60 due to sellers
50 S = $112.50 50
leaving market S
The height of this
triangle is 40 Two reasons for 40
$40 – 15 = $25. the fall in PS.
30 30
So, h
20 2. Fall in PS due to 20
PS = ½ x b x h
10 remaining sellers 10
= ½ x 25 x $25 getting lower P
= $312.50 0 Q 0 Q
0 5 10 15 20 25 30 0 5 10 15 20 25 30
CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 24 CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 25

ACTIVE LEARNING 2: What do CS, PS, and Total Surplus Measure?

supply curve
Producer Surplus 50
P
A. Find marginal 45 CS = (value to buyers) – (amount paid by buyers)
seller’s cost 40 = buyers’ benefit from participating in the market
at Q = 10. 35
B. Find total PS for PS = (amount received by sellers) – (cost to sellers)
30
P = $20. 25 = sellers’ benefit from participating in the market
Suppose P rises to $30. 20
Find the increase Total surplus = CS + PS
15
in PS due to… = total gains from trade in a market
10
C. selling 5
5
additional units
0
D. getting a higher price Q
0 5 10 15 20 25
on the initial 10 units
26 CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 27

The Market’s Allocation of Resources Measuring Society’s Well-Being

ƒ In a market economy, the allocation of resources Total surplus
is decentralized, determined by the interactions = CS + PS
of many self-interested buyers and sellers.
= (value to buyers) – (amount paid by buyers)
ƒ Is the market’s allocation of resources desirable? + (amount received by sellers) – (cost to sellers)
Or would a different allocation of resources make
society better off? = (value to buyers) – (cost to sellers)
ƒ To answer this, we use total surplus as a
measure of society’s well-being.

CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 28 CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 29

5
 Efficiency Efficiency
Total Total
= (value to buyers) – (cost to sellers) = (value to buyers) – (cost to sellers)
surplus 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.
ƒ Efficiency means making the pie as big as
possible.
ƒ In contrast, equity refers to whether the pie is
divided fairly.
ƒ What’s “fair” is subjective, harder to evaluate.
ƒ Hence, we focus on efficiency as the goal,
even though policymakers in the real world
usually care about equity, too.

CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 30 CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 31

Evaluating the Market Equilibrium Which Buyers Get to Consume the Good?
Market eq’m: P Every buyer 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 eq’m 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
CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 32 CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 33

Which Sellers Produce the Good? Does Eq’m Q Maximize Total Surplus?
Every seller whose P At Q = 20,
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 30
is only $20
Hence, the sellers 20 Hence, can increase 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
CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 34 CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 35

6
 Does Eq’m Q Maximize Total Surplus? Evaluating the Market Eq’m: Summary
At Q = 10, The market eq’m is efficient:
P
cost of producing • Eq’m Q maximizes total surplus.
the marginal unit 60
is $25 50 S • Goods produced by the lowest-cost producers.
value to consumers • Consumed by buyers who value them the most.
40
of the marginal unit Govt cannot improve on the market outcome.
is $40 30
Hence, can increase 20
Laissez faire (French for “allow them to do”):
total surplus the govt should not interfere with the market.
10
by increasing Q. D
This is true at any Q 0 Q
less than 15. 0 5 10 15 20 25 30
CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 36 CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 37

Why Non-Market Allocations Are Usually Bad
ƒ Suppose the allocation of resources were instead
determined by a central planner.
ƒ To choose efficient allocation, planner must know
• every seller’s cost
• every buyer’s WTP
for every good produced in the economy.
ƒ This is practically impossible.
Thus, centrally planned economies are never very
efficient.
CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS
Adam Smith and the Invisible Hand
Passages from The Wealth of Nations, 1776
“Man has almost constant occasion
for the help of his brethren, and it is
vain for him to expect it from their
benevolence only. He will be more
likely to prevail if he can interest their
self-love in his favor, and show them
that it is for their own advantage to do
for him what he requires of them…
It is not from the benevolence of the
butcher, the brewer, or the baker that
Adam Smith,
we expect our dinner, but from their
1723-1790
regard to their own interest….
38 CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 39

Adam Smith and the Invisible Hand CONCLUSION

Passages from The Wealth of Nations, 1776
“Every individual…neither intends to
promote the public interest, nor knows
how much he is promoting it….
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
Adam Smith,
that of the society more effectually than
1723-1790
when he really intends to promote it.”
CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 40
ƒ This chapter used welfare economics to
demonstrate one of the Ten Principles:
Markets are usually a good way to
organize economic activity.
ƒ But we assumed markets are perfectly competitive.
ƒ 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
CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 41

7
 CONCLUSION
ƒ When markets fail, public policy may remedy the
problem and increase efficiency.
ƒ Welfare economics sheds light on market
failures and govt policies.
ƒ Despite the possibility of market failure,
the assumptions in this chapter work well in
many markets, and the invisible hand remains
extremely important.
CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS
CHAPTER SUMMARY
ƒ 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.
ƒ Producer surplus is the difference between what
sellers receive for a good and their cost of
producing it.
ƒ On the graph, producer surplus is the area
between P and the S curve.
CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS
CHAPTER SUMMARY
ƒ The height of the D curve reflects the value of the
good to buyers—their willingness to pay for it.
ƒ Consumer surplus is the difference between what
buyers are willing to pay for a good and what they
actually pay.
ƒ On the graph, consumer surplus is the area
between P and the D curve.
42 CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 43
CHAPTER SUMMARY
ƒ To measure of society’s well-being, we use
total surplus, the sum of consumer and producer
surplus.
ƒ 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.
ƒ Under perfect competition, the market outcome is
efficient. Altering it would reduce total surplus.
44 CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS 45