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rkets CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS WHAT’S NEW IN THE SIXTH EDITION: There are no major changes to this chapter. 7 LEARNING OBJECTIVES: By the end of this chapter, students should understand: ??the link between buyers’ willingness to pay for a good and the demand curve. ??how to define and measure consumer surplus. ??the link between sellers’ costs of producing a good and the supply curve. ??how to define and measure producer surplus. ??that the equilibrium of supply and demand maximizes total surplus in a market.

CONTEXT AND PURPOSE: Chapter 7 is the first chapter in a three-chapter sequence on welfare economics and market efficiency. Chapter 7 employs the supply and demand model to develop consumer surplus and producer surplus as a measure of welfare and market efficiency. These concepts are then utilized in Chapters 8 and 9 to determine the winners and losers from taxation and restrictions on international trade.

The purpose of Chapter 7 is to develop welfare economics—the study of how the allocation of resources affects economic well-being. Chapters 4 through 6 employed supply and demand in a positive framework, which focused on the question, “What is the equilibrium price and

quantity in a market?” This chapter now addresses the normative question, “Is the equilibrium price and quantity in a market the best possible solution to the resource allocation problem, or is it simply the price and quantity that balance supply and demand?” Students will discover that under most circumstances the equilibrium price and quantity is also the one that maximizes welfare.

KEY POINTS: ??Consumer surplus equals buyers’ willingness to pay for a good minus the amount they actually pay for it, and it 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.

??Producer surplus equals the amount sellers receive for their goods minus their costs of production, and it 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. ??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 equality, of economic outcomes.

??The equilibrium of supply and demand maximizes the sum of consumer and producer surplus. That is, 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 such as market power or externalities. CHAPTER OUTLINE: I. Definition of welfare economics: the study of how the allocation of resources affects economic well-being. Students often are confused by the use of the word “welfare.” Remind them that we are talking about social well-being and not public assistance. II. Consumer Surplus A. Willingness to Pay 1. Definition of willingness to pay: the maximum amount that a buyer will pay for a good. 2. Example: You are auctioning a mint-condition recording of Elvis Presley’s first album. Four buyers show up. Their willingness to pay is as follows:

Students will understand consumer surplus if you take the time to work Table 1 through the Elvis Presley example. If you start with this simple example, students will have no trouble understanding how to find consumer surplus on Buyer Willingness to Pay John $100 Paul $80 George $70 Ringo $50 If the bidding goes to slightly higher than $80, all buyers drop out except for John. Because John is willing to pay more than he has to for the album, he derives some benefit from participating in the market.

“This represents the demand curve for the time machine. Consumer surplus is the difference between what consumers are willing to pay and the amount they actually have to pay. The market price will determine who uses the time machine and how much surplus they keep.” “If the price of a time machine ride was $500, three rides would be sold—one to Scott, one to Carol, and one to Steve. Jeanne is not willing to pay $500, so she wouldn’t time travel.” Activity 1—Value of a Time Machine “We can calculate the consumer surplus of three time trips. Scott would pay Type: In-class demonstration $3,000 but only pays $500, leaving $2,500 of net benefits.” (Put these Topics: Consumer surplus numbers on the board.) “Carol has net benefits of $2,000. Steve has $300 in Materials needed: None net benefits. Adding up these net savings gives $4,800 in consumer surplus.” Time: 10 minutes Points for Discussion Class limitations: Works in any size class The consumer surplus depends on a good’s selling price and the number of Purpose consumers who are willing to purchase the good at that price. The lower the Consumer surplus can be a hard concept for students because it is based on avoided expense rather than on money that is actually exchanged. This example puts a specific dollar value on consumer surplus. Instructions Tell the class, “A new technology has been developed that allows individuals to travel backward or forward in time. We want to identify the value this time machine provides to consumers. Let’s assume the four consumers who most desire this product are in this class.” Choose four student names and use them in the following example: “Scott is the consumer who most values this product. He wants to go back to the time of the dinosaurs. He is willing to pay $3,000.” “Carol is the consumer with the next highest willingness to pay. She would like to see 200 years in the future. She’d pay $2,500.” “Steve is the next highest bidder. He’d like to relive this entire semester. He’ll pay up to $800.” “Jeanne is our fourth consumer. She’d pay $200 to move the clock forward to the end of this class period.” On the board write: Scott $3,000 Carol $2,500 Steve $800 Jeanne $200

3. Definition of consumer surplus: the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it. 4. Note that if you had more than one copy of the album, the price in the auction would end up being lower (a little over $70 in the case of two albums) and both John and Paul would gain consumer surplus. B. Using the Demand Curve to Measure Consumer Surplus

1. We can use the information on willingness to pay to derive a demand curve for the rare Elvis Presley album. Price Buyers Quantity Demanded More than $100 None 0 $80 to $100 John 1 $70 to $80 John, Paul 2 $50 to $70 John, Paul, George 3 $50 or less John, Paul, George, 4 Ringo 2. At any given quantity, the price given by the demand curve reflects the willingness to pay Figure 1 of the marginal buyer. Because the demand curve shows the buyers’ willingness to pay, we can use the demand curve to measure consumer surplus. 3. Figure 2 Consumer surplus can be measured as the area below the demand curve and above the price. C. How a Lower Price Raises Consumer Surplus 1. Figure 3 As price falls, consumer surplus increases for two reasons. a. Those already buying the product will receive additional consumer surplus because they are paying less for the product than before (area A on the graph). b. Because the price is now lower, some new buyers will enter the market and receive consumer surplus on these additional units of output purchased (area B on the graph). D. What Does Consumer Surplus Measure? 1. Remember that consumer surplus is the difference between the amount that buyers are It is important to stress that consumer surplus is measured in monetary terms. willing to pay for a good and the price that they actually pay. Consumer surplus gives us a way to place a monetary cost on inefficient 2. Thus, it measures the benefit that consumers receive from the good as the buyers market outcomes (due to government involvement or market failure). themselves perceive it. ALTERNATIVE CLASSROOM EXAMPLE:

Review the material on price ceilings from Chapter 6. Redraw the market for two-bedroom apartments in your town. Draw in a price ceiling below the equilibrium price.

Then go through: ??consumer surplus before the price ceiling is put into place. ??consumer surplus after the price ceiling is put into place.

III. Producer Surplus A. Cost and the Willingness to Sell 1. Definition of cost: the value of everything a seller must give up to produce a good. You will need to take some time to explain the relationship between the 2. Example: You want to hire someone to paint your house. You accept bids for the work producers’ willingness to sell and the cost of producing the good. The from four sellers. Each painter is willing to work if the price you will pay exceeds her relationship between cost and the supply curve is not as apparent as the opportunity cost. (Note that this opportunity cost thus represents willingness to sell.) The costs relationship between the demand curve and willingness to pay. are: Seller Mary Frida Georgia Grandma Cost $900 $800 $600 $500 Table 2 3. Bidding will stop when the price gets to be slightly below $600. All sellers will drop out except for Grandma. Because Grandma receives more than she would require to paint the house, she derives some benefit from producing in the market. 4. Definition of producer surplus: the amount a seller is paid for a good minus the seller’s cost of providing it. 5. Note that if you had more than one house to paint, the price in the auction would end up being higher (a little under $800 in the case of two houses) and both Grandma and Georgia would gain producer surplus. B. Using the Supply Curve to Measure Producer Surplus 1. We can use the information on cost (willingness to sell) to derive a supply curve for house painting services. Price Sellers Quantity Supplied $900 or more Mary, Frida, Georgia, 4 Grandma $800 to $900 Frida, Georgia, Grandma 3 $600 to $800 Georgia, Grandma 2 $500 to $600 Grandma 1 less than $500 None 0 2. At any given quantity, the price given by the supply curve represents the cost of the marginal seller. Because the supply curve shows the sellers’ cost (willingness to sell), we can use the supply curve to measure producer surplus.

Figure 4 3. Figure 5 Producer surplus can be measured as the area above the supply curve and below the price. C. How a Higher Price Raises Producer Surplus 1. Figure 6 As price rises, producer surplus increases for two reasons. a. Those already selling the product will receive additional producer surplus because they are receiving more for the product than before (area C on the graph). b. Because the price is now higher, some new sellers will enter the market and receive producer surplus on these additional units of output sold (area D on the graph). D. Producer surplus is used to measure the economic well-being of producers, much like consumer surplus is used to measure the economic well-being of consumers. ALTERNATIVE CLASSROOM EXAMPLE:

Review the material on price floors from Chapter 6. Redraw the market for an agricultural product such as corn. Draw in a price support above the equilibrium price.

Then go through: ??producer surplus before the price support is put in place. ??producer surplus after the price support is put in place.

Make sure that you discuss the cost of the price support to taxpayers.