© 2011 Thomson South-Western. Welfare economics is the study of how the allocation of resources affects economic well- being.Welfare economics is the

© 2011 Thomson South-Western

Keren

A little short for one class. Could try to combine with application to taxation.Need to add some letters to graphs


• Welfare economics is the study of how the allocation of resources affects economic well-being.

• Buyers and sellers receive benefits from taking part in the market.

• The equilibrium in a market maximizes the total welfare of buyers and sellers.

Welfare Economics


CONSUMER SURPLUS• Willingness to pay (WTP) is the maximum

amount that a buyer will pay for a good.

• It measures how much the buyer values the good or service.


CONSUMER SURPLUS

• Consumer surplus is – the buyer’s willingness to pay for a good minus – the amount the buyer actually pays for it.


Figure 3 How the Price Affects Consumer Surplus

Consumersurplus

Quantity

(a) Consumer Surplus at Price P

Price

0

Demand

P1

Q1

B

A

C


Figure 3 How the Price Affects Consumer Surplus

Initialconsumer

surplus

Quantity

(b) Consumer Surplus at Price P

Price

0

Demand

A

BC

D EF

P1

Q1

P2

Q2

Consumer surplusto new consumers

Additional consumersurplus to initial consumers


What Does Consumer Surplus Measure?

• Consumer surplus:• the amount that buyers are willing to pay for a good

minus the amount they actually pay for it;

• measures the benefit that buyers receive from a good as the buyers themselves perceive it.


A C T I V E L E A R N I N G 1:

Consumer surplus

05

10152025

303540

4550

0 5 10 15 20 25

P$

Q

Demand curve

A. Find marginal buyer’s WTP at Q = 10.

B. Find CS for P = $30.

Suppose P falls to $20.How much will CS increase due to…

C. buyers entering the market

D. existing buyers paying lower price



Answers

05

10152025

303540

4550

0 5 10 15 20 25

P$

Q

Demand curve

A. At Q = 10, marginal buyer’s WTP is $30.

B. CS = ½ x 10 x $10 = $50

P falls to $20.

C. CS for the additional buyers = ½ x 10 x $10 = $50

D. Increase in CS on initial 10 units= 10 x $10 = $100


PRODUCER SURPLUS

• Producer surplus is the amount a seller is paid for a good minus the seller’s cost. – Cost here includes opportunity cost

• All out of pocket costs plus time costs

• It measures the benefit to sellers participating in a market.


Figure 6 How the Price Affects Producer Surplus

Producersurplus

Quantity

(a) Producer Surplus at Price P

Price

0

Supply

B

A

C

Q1

P1


Figure 6 How the Price Affects Producer Surplus

Quantity

(b) Producer Surplus at Price P

Price

0

P1B

C

Supply

A

Initialproducersurplus

Q1

P2

Q2

Producer surplusto new producers

Additional producersurplus to initialproducers

D EF



Producer Surplus

0

5

1015

20

25

30

3540

45

50

0 5 10 15 20 25

P

Q

Supply curve

A. Find marginal seller’s cost at Q = 10.

B. Find PS for P = $20.

Suppose P rises to $30.Find the increase in PS due to…

C. selling 5 additional units

D. getting a higher price on the initial 10 units



Answers

0

5

1015

20

25

30

3540

45

50

0 5 10 15 20 25

P

Q

Supply curve

A. At Q = 10, marginal cost = $20

B. PS = ½ x 10 x $20 = $100

P rises to $30.

C. PS on additional units= ½ x 5 x $10 = $25

D. Increase in PS on initial 10 units= 10 x $10 = $100


MARKET EFFICIENCY• Consumer surplus and producer surplus may

be used to address the following question:– Is the allocation of resources determined by free

markets in any way desirable?


The Benevolent Social Planner

Consumer Surplus

= Value to buyers – Amount paid by buyers

and

Producer Surplus

= Amount received by sellers – Cost to sellers



Total surplus

= Consumer surplus + Producer surplus

= (value to buyers) – (amount paid by buyers)

+ (amount received by sellers) – (cost to

sellers)

= (value to buyers) – (cost to sellers)

Total surplus

= Value to buyers – Cost to sellers

Keren

From here go to supply and demand curves, then example then skip to 3 lessons then to equity. Can also add back stuff on market failure.



• Efficiency is the property of a resource allocation of maximizing the total surplus received by all members of society.



• In addition to market efficiency, a social planner might also care about equity – the fairness of the distribution of well-being among the various buyers and sellers.


Figure 7 Consumer and Producer Surplus in the Market Equilibrium

Producersurplus

Consumersurplus

Price

0 Quantity

Equilibriumprice

Equilibriumquantity

Supply

Demand

A

C

B

D

E


Evaluating the Market Equilibrium

• Three Insights Concerning Market Outcomes• Free markets allocate the supply of goods to the

buyers who value them most highly, as measured by their willingness to pay.

• Free markets allocate the demand for goods to the sellers who can produce them at least cost.

• Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.


Which Buyers Get to Consume the Good?

0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

S

D

Every buyer whose WTP is ≥ $30 will buy.

Every buyer whose WTP is < $30 will not.

So, the buyers who value the good most highly are the ones who consume it.


Which Sellers Produce the Good?

0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

S

D

Every seller whose cost is ≤ $30 will produce the good.

Every seller whose cost is > $30 will not.

Hence, the sellers with the lowest cost produce the good.


Does Eq’m Q Maximize Total Surplus?

0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

S

D

At Q = 20, cost of producing the marginal unit is $35

value to consumers of the marginal unit is only $20

Hence, can increase total surplus by reducing Q.

This is true at any Q greater than 15.


Does Eq’m Q Maximize Total Surplus?

0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

S

D

At Q = 10, cost of producing the marginal unit is $25

value to consumers of the marginal unit is $40

Hence, can increase total surplus by increasing Q.

This is true at any Q less than 15.


Figure 8 The Efficiency of the Equilibrium Quantity

Quantity

Price

0

Supply

Demand

Costto

sellers

Costto

sellers

Valueto

buyers

Valueto

buyers

Value to buyers is greaterthan cost to sellers.

Value to buyers is lessthan cost to sellers.

Equilibriumquantity


Evaluating the Market Equilibrium

• Because the equilibrium outcome is an efficient allocation of resources, the social planner can leave the market outcome as he/she finds it.

• This policy of leaving well enough alone goes by the French expression laissez faire.

Documents

© 2011 Thomson South-Western. Welfare economics is the study of how the allocation of resources affects economic well- being.Welfare economics is the