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SUPPLY AND DEMAND II: MARKETS AND WELFARE
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7
Consumers, Producers, and the
Efficiency of Markets
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 3
Revisiting The Market Equilibrium
• The theory of supply and demand shows howmarkets allocate scarce resources amongcompeting needs.
• But are the equilibrium price and quantity theright price and the right quantity from society’spoint 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.
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 4
Welfare Economics
• Welfare economics is the study of how theallocation of resources affects economicwell-being
• It shows that: – Both buyers and sellers receive benefits from
taking part in the market
– The equilibrium outcome—that we saw inChapter 4—maximizes the total welfare ofbuyers and sellers
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 5
Welfare Economics: two mainconcepts
• Consumer surplus measures economicwelfare of the buyer.
• Producer surplus measures economicwelfare of the seller.
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 6
Willingness to pay
• To define consumer surplus we first needto 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.
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Willingness to pay
• Assume there is a commodity such that everyadditional unit of it increases a consumer’shappiness by the same amount
– In other words, the consumption of additionalunits of this commodity induces neither boredomnor addiction
– Possible examples: potato chips? candy?
• Then the consumer’s willingness to pay for aproduct is an accurate measure of thehappiness that he or she gets from it
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Willingness to pay
• continuation from previous slide
• If a bag of potato chips provides an unchangingamount 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
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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 shirtis
– a monetary measure of the happiness you get fromthe shirt, which is – proportional to the happiness you get from the shirt,
as measured in ―haps‖
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Table 1 Four Possible Buyers’ Willingness to Pay
For a mint-conditionrecording of ElvisPresley’s first album
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Consumer Surplus
• Consumer surplus is the buyer’s willingness topay for a good minus the amount the buyeractually pays for it.
– Example: If the Elvis album’s price is $75…
Buyer Willingnessto Pay
ConsumerSurplus
Buy?
John 100 25 YesPaul 80 5 Yes
George 70 -5 No
Ringo 50 -25 No
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 12
Market Demand
• The market demand schedule/curve showsthe various quantities that buyers would bewilling and able to purchase at different prices.
– Chapter 4• We can use the willingness-to-pay numbers to
calculate the quantities demanded at everyprice
– That is, we can calculate the market demandschedule/curve from the willingness-to-paynumbers
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The Demand Schedule Buyer Willingness
to Pay
John 100
Paul 80
George 70
Ringo 50
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Figure 1 The Demand Curve
Copyright©2003 Southwestern/Thomson Learning
Price of Album
0 Quantity of Albums
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 thedemand curve at any
quantity shows thewillingness to pay ofwhoever bought thelast unit.
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 15
Area of a Rectangle
Height
Width
Area = Width × Height
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Figure 2 Measuring Consumer Surplus with theDemand Curve
(a) Price = $80.01 Price of
Album
50 70 80
0
$100
Demand
1 2 3 4 Quantity of Albums
John’s willingness to pay ($100)
Buyer Willingnessto Pay
ConsumerSurplus
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 totalwillingness to pay for thequantity demanded.
2. It is also the maximumwillingness to pay that couldbe generated from thatquantity.
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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. Thegovernment’s goal is to give it toone of the four guys so as togenerate the maximum happiness.
• Who will get the government’scopy?
• Obviously, John.• Lesson: The market does thebest that the government couldhave done
Price = $80
Buyer Willingnessto Pay
John 100
Paul 80
George 70
Ringo 50
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Figure 2 Measuring Consumer Surplus with theDemand Curve
(b) Price = $70.01 Price of
Album
50
70 80
0
$100
Demand 1 2 3 4 Quantity of
Albums
Buyer Willingnessto Pay
ConsumerSurplus
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 totalwillingness to pay for thequantity demanded.
2. It is also the maximumwillingness to pay that could
be generated from thatquantity.
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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—thatprovides 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
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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 sumof the numbers representing the happiness of theindividual 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 takesutilitarianism as its guiding philosophy
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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. Thegovernment’s goal is to give them
to two of the four guys so as togenerate the maximum happiness.
• Who will get the government’scopies?
• Obviously, John and Paul.
• The market does the best thatthe government could have done
Price = $70
Buyer Willingnessto Pay
John 100
Paul 80
George 70
Ringo 50
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Willingness to Pay from the Demand Curve
Quantity
(a) Willingness to Pay at Price P Price
0
Demand
P 1
Q 1
B
A
C
The area under the demandcurve also measures themaximum willingness to pay
that could be obtained fromQ 1 units
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 23
Using the demand curve to measurewillingness to pay
• In general, the area under the demandcurve up to the quantity demanded is agraphical measure of the total willingness
to pay of the buyers.
• It is also the maximum willingness to paythat can be obtained from that quantity
– That is, the government could not give awaythat quantity in a way that generates higherwillingness to pay.
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Figure 3 How the Price Affects ConsumerSurplus
Consumer surplus
Quantity
(a) Consumer Surplus at Price P Price
0
Demand
P 1
Q 1
B
A
C
TotalPayment
Consumer Surplus (ABC) +Total Payment (OBCQ1) =Willingness to Pay (OACQ1)
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 28
Using the Demand Curve to MeasureConsumer Surplus
• In general, the area below the demand curve and above the price measures theconsumer surplus.
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Figure 3 How the Price Affects ConsumerSurplus
Initial consumer
surplus
Quantity
(b) Consumer Surplus at Price P Price
0
Demand
A
B C
D E F
P 1
Q 1
P 2
Q 2
Consumer surplus to new consumers
Additional consumer surplus to initial
consumers
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Shifts in Demand
• We have seen that the demand curve canshift, 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 shiftas a result of a change in the price of arelated good, does it make sense to say that
the area under the demand curve measuresthe happiness consumers get from theproduct?
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 30
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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 beunchanged 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 thatprovided 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 $30 for the same shirt,leading to an upward shift in the demand curve for shirts.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 31
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 33
Producer Surplus
• Producer surplus is the amount a seller ispaid for a good minus the seller’s cost .
• It measures the net benefit to sellers
• It is almost but not quite the same as profit. – We’ll discuss this later
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 34
Cost of production
• The cost of production is the market valueof all resources used in production
– By all , I do mean all . Even if some resources
used in production were obtained for free,their market value must be included in cost .
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Table 2 The Cost of Painting a House forFour Possible Sellers
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 36
The Supply Schedule and theSupply Curve
Seller Cost ($)
Mary 900
Frida 800
Georgia 600
Grandma 500
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Figure 4 The Supply Schedule and the SupplyCurve
Seller Cost ($)
Mary 900
Frida 800
Georgia 600
Grandma 500
The height of the supply curveat any quantity shows theproduction cost to whoeverproduces the last unit.
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 38
Producer Surplus
• Producer surplus is the amount a seller is paidminus the seller’s cost
– Example: If the going price for getting a house paintedis $700 we get the following table.
Seller Cost ($) ProducerSurplus
Sell?
Mary 900 -200 No
Frida 800 -100 No
Georgia 600 100 Yes
Grandma 500 200 Yes
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 39
Using the Supply Curve to MeasureProducer Surplus
• The area below the price and above thesupply curve measures the producersurplus.
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Figure 5 Measuring Producer Surplus with theSupply Curve
Quantity of Houses Painted
Price of House Painting
500
800
$900
0
600
1 2 3 4
(a) Price = $599.99
Supply
Grandma’s Cost($500)
Seller Cost ($) ProducerSurplus
Sell?
Mary 900 -300 No
Frida 800 -200 No
Georgia 600 0 No
Grandma 500 100 Yes
1. The area under
the supply curve isthe cost of thequantity supplied
2. It is also thelowest cost for thatquantity
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 43
Is there a better alternative to themarket system?
• If the government had to get one house painted, who would get the
job?
• Grandma, of course, if thegovernment had any sense.
• And that’s exactly what happensin the market outcome.
• The market achieves the bestthat the government could haveachieved
Seller Cost ($)
Mary 900
Frida 800
Georgia 600
Grandma 500
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Figure 5 Measuring Producer Surplus with theSupply Curve
Quantity of Houses Painted
Price of House Painting
500
800 $900
0
600
1 2 3 4
(b) Price = $799.99
Supply
Seller Cost ($) ProducerSurplus
Sell?
Mary 900 -100 No
Frida 800 0 No
Georgia 600 200 Yes
Grandma 500 300 Yes
Grandma’s cost
Georgia’s cost
1. The area under
the supply curve isthe cost of thequantity supplied
2. It is also thelowest cost for thatquantity
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 45
Is there a better alternative to themarket system?
• If the government had to get two houses painted, who would getthe job?
• Grandma and Georgia, of course.• And that’s exactly what happens
in the market outcome.
• The market achieves the bestthat the government could haveachieved
Seller Cost ($)
Mary 900
Frida 800
Georgia 600
Grandma 500
Figure 6 How the Price Affects Producer
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Figure 6 How the Price Affects ProducerSurplus
Producer surplus
Quantity
(a) Producer Surplus at Price P Price
0
Supply
B
A
C
Q 1
P 1
ProductionCost
Total Revenue (OBCQ1) =Production Cost (OACQ1) +Producer Surplus (ABC)
Figure 6 How the Price Affects Producer
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Figure 6 How the Price Affects ProducerSurplus
Quantity
(b) Producer Surplus at Price P Price
0
P 1 B C
Supply
A
Initial producer surplus
Q 1
P 2
Q 2
Producer surplus to new producers
Additional producer surplus to initial producers
D
E
F
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 49
MARKET EFFICIENCY
• Consumer surplus and producer surplusmay be used to address the followingquestions:
– Is our free market system a good way ofrunning our economy?
– Could we design a better system?
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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 tosellers
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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 tosellers
= Value to buyers – Cost to sellers
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MARKET EFFICIENCY
• In fact, we can go further and say that
• Total Surplus = maximum willingness topay – minimum production cost
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 52
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 53
MARKET EFFICIENCY
• An economic outcome is efficient if there isno feasible way to make the total surplusany higher.
Figure 7 Consumer and Producer Surplus in
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Figure 7 Consumer and Producer Surplus inthe Market Equilibrium
Producer surplus
Consumer surplus
Price
0 Quantity
Equilibrium price
Equilibrium quantity
Supply
Demand
A
C B
D
E
Figure 7 Consumer and Producer Surplus in
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Cost
Consumer surplus
g pthe Market Equilibrium
Producer surplus
Price
0 Quantity
Equilibrium price
Equilibrium quantity
Supply
Demand
A
C B
D
E
Total Value (or,willingness to pay)
TotalSurplus
Th b f ibl
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Cost (also,Minimum Cost)
Consumer surplus
The best feasible outcome
Producer surplus
Price
0 Quantity
Equilibrium price
Equilibrium quantity
Supply
Demand
A
C B
D
E
Total Value (also,Maximum Value)
Maximum TotalSurplus
As long as we producethe equilibrium quantity,
it would be impossibleto increase the TotalSurplus by reallocatingproduction andconsumption.
But is the
equilibriumoutput the rightoutput toproduce?
The best feasible outcome
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Maximum Cost saved
The best feasible outcome
Price
0 Quantity
Equilibrium price
Equilibrium quantity
Supply
Demand
A
C B
D
E
Minimum WTP lost
Alternative
Society would beworse off if it produces
less than theequilibrium quantity
The best feasible outcome
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Minimum Cost
The best feasible outcome
Price
0 Quantity
Equilibrium price
Equilibrium quantity
Supply
Demand
A
C B
D
E
Society would beworse off if it produces
more than theequilibrium quantity
Maximum Value ofextraoutput
Alternative
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 59
MARKET EFFICIENCY
• Three Insights Concerning MarketOutcomes
– Free markets allocate the goods produced to
the buyers who value them most highly, asmeasured by their willingness to pay.
– Free markets allocate production of goods tothose who can produce them at least cost.
– Free markets produce the quantity of goodsthat maximizes the sum of consumer andproducer surplus.
Figure 8 The Efficiency of the Equilibrium
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Figure 8 The Efficiency of the EquilibriumQuantity
Quantity
Price
0
Supply
Demand
Cost to
sellers
Cost to
sellers
Value to
buyers
Value to
buyers
Value to buyers is greater than cost to sellers. Value to buyers is less
than cost to sellers.
Equilibrium quantity
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 62
The Invisible Hand
• We pursue our self-interest, not the socialinterest
• 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 byAdam Smith (1723 – 1790), the father ofmodern economics.
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 63
The Invisible Hand
• ...[E]very individual … neither intends to promote thepublic interest, nor knows how much he is promoting it.… [H]e intends only his own security; and by directingthat industry in such a manner as its produce may be ofthe greatest value, he intends only his own gain, and he
is in this, as in many other cases, led by an invisiblehand to promote an end which was no part of hisintention. Nor is it always the worse for the society that itwas no part of it. By pursuing his own interest hefrequently promotes that of the society more effectuallythan when he really intends to promote it. I have neverknown much good done by those who affected to tradefor the public good.
• The Wealth of Nations , Adam Smith, 1776
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 64
Ticket Scalping
• Ticket scalping is often frowned upon andsometimes considered illegal – See http://en.wikipedia.org/wiki/Ticket_resale
• But a typical view among economists isthat ―consenting adults should be able tomake economic trades when they think itis to their mutual advantage‖
• Scalping increases the economy’sefficiency
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 65
Market for organs
• Should people be allowed to sell, say, theirkidneys?
• 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 withtaxpayers’ money so that rich and poor had equalaccess
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WHEN MARKETS FAIL
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 66
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 67
However, markets can go wrong
• Market Power
• Externalities
• Fairness
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 68
MONOPOLY
• If a market system is not perfectlycompetitive, firms may have market power .
– Market power is the ability to influence prices.
– Market power can cause markets to beinefficient because it keeps price and quantityfrom the equilibrium of supply and demand.
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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 thatmarket.
– cause welfare in a market to depend on morethan just the value to the buyers and cost tothe sellers.
• When buyers and sellers do not take externalities
into account when deciding how much toconsume and produce, the equilibrium in themarket can be inefficient.
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 70
FAIRNESS
• In addition to market efficiency, a socialplanner might also care about equity – thefairness of the distribution of well-being
among the various buyers and sellers.• The free market economic system is
efficient but not necessarily fair
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Health Care: a big exception
• In most advanced countries, government policiesregarding health care routinely disregard the idea thatfree markets are best
• In the United Kingdom, the government buildshospitals, hires doctors and nurses, buys
pharmaceutical drugs, and provides medical care to allresidents• 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
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 72
Summary
• Consumer surplus equals buyers’willingness to pay for a good minus theamount they actually pay for it.
• Consumer surplus measures the benefitbuyers get from participating in a market.
• Consumer surplus can be computed by
finding the area below the demand curveand above the price.
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 73
Summary
• Producer surplus equals the amount sellersreceive for their goods minus their costs ofproduction.
• Producer surplus measures the benefitsellers get from participating in a market.
• Producer surplus can be computed by
finding the area below the price and abovethe supply curve.
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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 74
Summary
• An allocation of resources that maximizesthe sum of consumer and producer surplusis said to be efficient.
• Policymakers are often concerned with theefficiency, as well as the equity, ofeconomic outcomes.
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Summary
• The equilibrium of demand and supplymaximizes the sum of consumer andproducer surplus.
• This is as if the invisible hand of themarketplace leads buyers and sellers toallocate resources efficiently.
• Markets do not allocate resourcesefficiently in the presence of marketfailures.