consumers, producers and market efficiency lecture 5 – academic year 2014/15 introduction to...
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Consumers, Producers and Market Efficiency
Lecture 5 – academic year 2014/15Introduction to Economics
Fabio Landini
Where are we…
• Lecture 1 : Demand and supply model• Lecture 2: Elasticity and its application• Lecture 4: Demand, Supply and economic
policy
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What do we do today?
• Allocative efficiency: – how do we measure the welfare of both consumers and producers?
• Consumer surplus• Producer surplus• THE INVISIBLE HAND THEOREM
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QUICK QUIZIf the equilibrium price on the market for
cigarettes is equal to 10 Euro a pack, and Government introduces a MAXIMUM price equal to 12 Euro, we obtain…
A) … Excess supply: the quantity supplied is greater than the quantity demanded.
B) ... Scarcity: the quantity demanded is greater than the quantity supplied.
C) ... No effect on the market.4
Premise: What’s an auction?
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Two issues
1. Is there a RIGHT price?• Consumers: prices are ALWAYS too high;• Producers: prices are ALWAYS too low.
How do we understand which is the ‘right’ price?
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2. Is the MARKET EQUILIBRIUM (that is: p & q) right?
• So far: positive analysis of the market;• Now: normative analysis;• We ask: Is the resource allocation produced
by the market desirable? In which sense?• How do we measure welfare?
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Two issues
Welfare measure
The consumer surplus measures the benefit that the consumer obtains from participating to the market.
The producer surplus measures the same benefit for the producer.
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Consumer surplus
Willingness to pay: it is the maximum amount that the consumer is willing to pay to obtain the good.
It measures the value that the consumer attaches to the good or service.
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The demand curve describes the quantity that consumers are willing to buy at different prices.
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Consumer surplus
The consumer surplus is the difference between the consumer’s willingness to pay and the price that is effectively paid.
Example: willingness to pay for a rare Elvis’s record?
Consumer Willingness to pay
John 100
Paul 80
George 70
Ringo 50
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Summary: demand table
Price Consumers QuantityDemanded
>100 None 0
80 -100 John 1
70 - 80 John, Paul 2
50 - 70 John, Paul, George 3
< 50 John, Paul, George, Ringo 4
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Consumer surplus and demand curve – Price=80
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Price
50
7080
0
100
1 2 3 4 Quantity
Consumer surplus John (20 euro)
Consumer surplus and demand curve – Price=70
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Price
50
7080
0
100
1 2 3 4 Quantity
Consumer surplus John (30 euro)
Consumer surplus Paul (10 euro)
Total consumer surplus(40 euro)
Consumer surplus and demand curve – Price=70
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Price
50
7080
0
100
1 2 3 4 Quantity
Consumer surplus John (30 euro)
Consumer surplus Paul (10 euro)
Total consumer surplus(40 euro)
Domanda
Consumer surplus and price
Consumer surplus = area in between the demand curve and the price level.
There exist a negative relationship between price and consumer surplus.
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Effects of price variations on consumer surplus
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Demand
Quantity
Price
0
P1
Q1
Surplus of initial
consumer
A
B C
Effects of price variations on consumer surplus
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Demand
Quantity
Price
0
P1
Q1
Surplus of initial
consumer
A
B C
P2
Q2
FD
Effects of price variations on consumer surplus
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Demand
Quantity
Price
0
P1
Q1
Surplus of initial
consumer
A
B C
P2
Q2
F
Surplus for the new consumer
DAdditional surplus for the initial consumer
E
Producer surplus
Supply curve•It describes the quantity that the producers are willing to sell for each price;•The willingness to sell is determined by the costs of production (measured as an opportunity cost);•As the market price increases, less efficient producers can enter the market
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Producer surplus
The producer surplus is the difference between the price paid by the consumer and the cost of production.
It measures the benefit that the producer obtains from participating to the market.
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Example: willingness to sell a rare Elvis’s record?
Producer Costs
Mick 900
Keith 800
Charli 600
Bill 500
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Summary: Table of supplyPrice Sellers Quantity
supplied
P > 900 Bill, Charlie, Keith e Mick 4
800 -900 Bill, Charlie, Keith 3
600 -800 Bill, Charlie 2
500 - 600 Bill 1
P < 500 None 023
To measure the producer surplus with the supply curve
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Quantity
Price
500
800
900
0
600
1 2 3
Bill’s surplus (100 euro) if p=600
To measure the producer surplus with the supply curve
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Quantity
Price
500
800
900
0
600
1 2 3
Bill’s surplus (300 euro) if p=800
Charlie’s surplus (200 euro) if p=800
Total producer surplus (500 euro)
To measure the producer surplus with the supply curve
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Quantity
Price
500
800
900
0
600
1 2 3
Bill’s surplus (300 euro) if p=800
Charlie’s surplus (200 euro) if p=800
Total producer surplus (500 euro)
Supply
Effects of price variations on producer surplus
27Quantity
Price
0
P1B
C
Supply
A
Surplus of initial
producer
Q1 Q2
Effects of price variations on producer surplus
28Quantity
Price
0
P1B
C
Supply
A
Surplus of initial
producer
Q1 Q2
P2
Q2
Effects of price variations on producer surplus
29Quantity
Price
0
P1B
C
Supply
A
Surplus of initial
producer
Q1 Q2
P2
Q2
BC
A
DF
Surplus for the new producer
Additional surplus for initial producer
Market efficiency
In a market with perfect competition and no externalities:•Social welfare = consumer surplus + producer surplus
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Consumer surplus and producer surplus in equilibrium
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Price
Equilibrium price
0 QuantityEquilibrium quantity
A
Supply
C
BDemand
D
E
Consumer surplus and producer surplus in equilibrium
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Price
Equilibrium price
0 QuantityEquilibrium quantity
A
Supply
C
BDemand
D
E
Producer surplus
Consumer surplus and producer surplus in equilibrium
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Price
Equilibrium price
0 QuantityEquilibrium quantity
A
Supply
C
BDemand
D
E
Producer surplus
Consumer surplus
Allocative efficiency
Allocative efficiency obtains when the allocation of resources maximizes total surplus.
Does a perfectly competitive market achieve allocative efficiency?
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Market equilibrium and allocative efficiency
In a free market:• The supply of a good goes to those consumers
that evaluate the good the most.• The demand of a good is satisfied by the
sellers that con produce the good at the lowest cost.
• The quantity of good that maximizes the sum of consumer surplus and producer surplus is finally produced.
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Graphical demonstration
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Quantity
Price
0 Equilibrium quantity
Supply
Demand
Cost for the
producer
Value for the consumer
The value for the consumeris greater than the costfor the producer.
The value for the consumeris lower than the costfor the producer.
Cost for the
producer
Value for the consumer
The invisible hand
In a free market there exist several producers and consumers, each motivated by her own self-interest.Thanks to the price system (= impersonal coordination and communication device):•Individual decisions of producers and consumers leads to an efficient allocation of resources.
This is the INVISIBLE HAND THEOREM.
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Does the invisible hand theorem always hold?
No, in two cases at least:1.Market power;2.Externalities.
In these cases we usually talk about MARKET FAILURES.
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Market power
• Market power= when consumers or producers have some control over market prices – we talk about “imperfect competition” (monopoly, oligopoly).
• Market power generates inefficiencies (=“market failures”), because market prices do not reflect social cost of resources.
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Externalities
Externalities: when the decisions of consumers and producers have “external effects”, i.e. effects (both costs and benefits) on individuals that do not participate to the market.
Externalities generate inefficiencies (= “market failures”), because market prices do not reflect the social cost of resources.
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Welfare
Consumer surplus and producer surplus measure the benefits that consumers and producers can derive from participating to the market
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Efficiency
An allocation of resources that maximizes the total surplus (= consumer surplus + producer surplus) is called “efficient”
The existence of market power and externalities can lead to inefficient results and market failures
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Conclusions
Keep in mind: social welfare is not only efficiency, but also equity!
We will talk about that later in the course….
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Next week
Economic policy and efficiency: exercises and applications
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