Micro Ch07 Presentation

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

these questions:
What is consumer surplus? How is it related to
the demand curve?
PRINCIPLES OF
What is producer surplus? How is it related to the
MICROECONOMICS
supply curve?
FOURTH EDITION
Do markets produce a desirable allocation of

resources? Or could the market outcome be
improved upon?
N. G R E G O R Y M A N K I W
Premium PowerPoint Slides
by Ron Cronovich
2007 update
CHAPTER 7
2008 Thomson South-Western, all rights reserved
Willingness to Pay (WTP)
Welfare Economics
Recall, the allocation of resources refers to:
how much of each good is produced
which producers produce it
which consumers consume it
Welfare economics studies how the allocation
A buyers willingness to pay for a good is the

maximum amount the buyer will pay for that good.
WTP measures how much the buyer values the
good.
name
of resources affects economic well-being.
CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS
Chad
175
Flea
300
John
125
CHAPTER 7
WTP and the Demand Curve
A: Anthony & Flea will buy an iPod,

Chad & John will not.
WTP
Anthony $250
Derive the
demand
schedule:
name
Hence, Qd = 2
when P = $200.
WTP
Anthony $250
175
Chad
175
Flea
300
Flea
300
John
125
John
125
Chad
CHAPTER 7
Example:
4 buyers WTP
for an iPod
Q: If price of iPod is $200, who will buy an iPod,

and what is quantity demanded?
name
WTP
Anthony $250
First, we look at the well-being of consumers.
CHAPTER 7
CHAPTER 7
P (price
of iPod)
who buys
Qd
$301 & up nobody
251 300 Flea
176 250 Anthony, Flea
126 175
0 125
Chad, Anthony,
Flea
John, Chad,
Anthony, Flea
About the Staircase Shape
$350
$300
$250
$200
$150
$100
$50
$0
0
CHAPTER 7
P
$301 & up
251 300
$250
$200
176 250
$150
126 175
0 125
$100
$50
If there were a huge # of buyers,

as in a competitive market,
there would be a huge #
of very tiny steps,
and it would look
more like a smooth
curve.
$0
CHAPTER 7

P
Fleas WTP
$350
$300
Anthonys WTP
$250
$200
Chads WTP
Johns
WTP
$150
$100
$50
$0
CHAPTER 7
At any Q,
the height of
the D curve is
the WTP of the
marginal buyer,
the buyer who
would leave the
market if P were
any higher.
CS = WTP P
name
Chad
175
Flea
300
The others get no CS because

they do not buy an iPod at this
price.
John
125
Total CS = $40.
CHAPTER 7
$150
$100
$50
CHAPTER 7
Fleas WTP
Anthonys WTP
Fleas CS =
$300 220 = $80
Total CS = $110
0
10
Instead, suppose
P = $220
Anthonys CS =
$250 220 = $30
$0
$250
$200
$100
$50
1
Fleas CS = $300 260 = $40.
Anthony $250
$150
Suppose P = $260.
WTP
$350
$300
Total CS = $40
$0
CS and the Demand Curve
Fleas CS =
$300 260 = $40
$250
$200
P = $260
Fleas WTP
Consumer surplus is the amount a buyer is willing

to pay minus the amount the buyer actually pays:

$350
$300
Consumer Surplus (CS)
This D curve looks like a staircase

with 4 steps one per buyer.
$350
$300
Qd
CHAPTER 7
11
CS with Lots of Buyers & a Smooth D Curve
$350
$300
At Q = 5(thousand),
Price
P
the marginal buyer
per pair
$ 60
is willing to pay $50
50
for pair of shoes.
The lesson:
Total CS equals
the area under
the demand curve
above the price,
from 0 to Q.
$250
$200
$150
$100
$50
Suppose P = $30.
40
Then his consumer

surplus = $20.
30
The demand for shoes
1000s of pairs
of shoes
20
10
$0
0
CHAPTER 7
4
12
CS with Lots of Buyers & a Smooth D Curve
Recall: area of
a triangle equals
x base x height
Height =
$60 30 = $30.
So,
CS = x 15 x $30
= $225.
CHAPTER 7
5 10 15 20 25 30
13
How a Higher Price Reduces CS
$ 60
CS = x 10 x $20
= $100.
50
h
40
Two reasons for the

fall in CS.
30
P
60
50
1. Fall in CS
due to buyers
leaving market
40
30
20
10
2. Fall in CS due to
remaining buyers
paying higher P
0
0
ACTIVE LEARNING
Consumer surplus 50
P
1:
5 10 15 20 25 30
10
D
Q
0
14
CHAPTER 7
5 10 15 20 25 30
15
Cost and the Supply Curve

Cost is the value of everything a seller must give
demand curve
$ 45
40
35
B. Find CS for
30
P = $30.
25
Suppose P falls to $20. 20
How much will CS
15
increase due to
10
C. buyers entering
5
the market
0
D. existing buyers
0
paying lower price
20
A. Find marginal
buyers WTP at
Q = 10.
CHAPTER 7
If P rises to $40,
The demand for shoes
Q
0
CS is the area b/w

P and the D curve,
from 0 to Q.
up to produce a good (i.e., opportunity cost).
Includes cost of all resources used to produce

good, including value of the sellers time.
Example: Costs of 3 sellers in the lawn-cutting

business.
10
15
20
Q
25
16
name
cost
Angelo
$10
Hunter
20
Kitty
35
CHAPTER 7
A seller will only produce and

sell the good if the price
exceeds his or her cost.
Hence, cost is a measure of
willingness to sell.
17

P
Derive the supply schedule

from the cost data:
name
cost
Angelo
$10
Hunter
20
Kitty
CHAPTER 7
$40
Qs
$0 9
10 19
20 34
35 & up
$30
$20
$10
$0
35
18
CHAPTER 7
P
Kittys
cost
$30
$20
Hunters
cost
$10
Angelos cost
$0
CHAPTER 7
At each Q, the
height of the S curve
is the cost of the
marginal seller,
the seller who would
leave the market if
the price were any
lower.
20
Kittys
cost
$30
$20
Hunters
cost
$10
Angelos cost
$0
0
CHAPTER 7
35 & up
19
PS = P cost
Producer surplus (PS):

the amount a seller
is paid for a good
minus the sellers cost.
$30
$20
$10
Q
CHAPTER 7
Suppose P = $40.
Price
per
pair
At Q = 15(thousand),
Suppose P = $25.
Angelos PS = $15
Hunters PS = $5
the marginal sellers

cost is $30,
and her producer
surplus is $10.
Kittys PS = $0
21
Total PS equals the

area above the supply
curve under the price,
from 0 to Q.
22
The supply of shoes
60
50
40
30
1000s of pairs
of shoes
20
Total PS = $20
20 34
PS with Lots of Sellers & a Smooth S Curve
PS = P cost
$40
Producer Surplus and the S Curve

$40
$0
10 19
Producer Surplus

$40
$0 9
Qs
10
0
Q
0
CHAPTER 7
5 10 15 20 25 30
23
PS with Lots of Sellers & a Smooth S Curve

PS is the area b/w
P and the S curve,
from 0 to Q.
The height of this
triangle is
$40 15 = $25.
So,
PS = x b x h
= x 25 x $25
= $312.50
60
50
40
30
h
20
ACTIVE LEARNING
60
Two reasons for

the fall in PS.
40
2:
CHAPTER 7
30
20
10
Q
0
24
1. Fall in PS
due to sellers
leaving market
P
50
A. Find marginal
45
sellers cost
40
at Q = 10.
35
B. Find total PS for
30
P = $20.
25
Suppose P rises to $30. 20
Find the increase
15
in PS due to
10
C. selling 5
5
additional units
0
D. getting a higher price
0
on the initial 10 units
50
5 10 15 20 25 30
Producer Surplus
PS = x 15 x $15
= $112.50
2. Fall in PS due to
remaining sellers
getting lower P
10
0
CHAPTER 7
If P falls to $30,
The supply of shoes
How a Lower Price Reduces PS
5 10 15 20 25 30
25
What do CS, PS, and Total Surplus Measure?
supply curve
CS = (value to buyers) (amount paid by buyers)

= buyers benefit from participating in the market
PS = (amount received by sellers) (cost to sellers)
= sellers benefit from participating in the market
Total surplus = CS + PS
= total gains from trade in a market
10
15
20
Q
25
26
CHAPTER 7
27
Measuring Societys Well-Being
The Markets Allocation of Resources
In a market economy, the allocation of resources
Total surplus
is decentralized, determined by the interactions

of many self-interested buyers and sellers.
= CS + PS
Is the markets allocation of resources desirable?

Or would a different allocation of resources make
society better off?
= (value to buyers) (amount paid by buyers)

+ (amount received by sellers) (cost to sellers)
= (value to buyers) (cost to sellers)
To answer this, we use total surplus as a

measure of societys well-being.
CHAPTER 7
28
CHAPTER 7
29
Efficiency
Efficiency
Total
surplus
Total
surplus
Efficiency means making the pie as big as
An allocation of resources is efficient if it maximizes

total surplus. Efficiency means:
possible.
Raising or lowering the quantity of a good
In contrast, equity refers to whether the pie is

divided fairly.
would not increase total surplus.
The goods are being produced by the producers
Whats fair is subjective, harder to evaluate.

Hence, we focus on efficiency as the goal,
with lowest cost.
The goods are being consumed by the buyers
even though policymakers in the real world

usually care about equity, too.
who value them most highly.

CHAPTER 7
30
Evaluating the Market Equilibrium

Market eqm:
P = $30
Q = 15,000
Total surplus
= CS + PS
Is the market eqm
efficient?
60
S
CS
30
PS
20
10
Q
0
CHAPTER 7
Every buyer
whose WTP is
$30 will buy.
50
Every seller whose

cost is > $30 will
not.
Hence, the sellers
with the lowest cost
produce the good.
32
60
50
40
30
20
Q
0
CHAPTER 7
40
30
20
10
5 10 15 20 25 30
CHAPTER 7
5 10 15 20 25 30
33
Does Eqm Q Maximize Total Surplus?
10
So, the buyers who

value the good most
highly are the ones
who consume it.
50
Which Sellers Produce the Good?

Every seller whose
cost is $30 will
produce the good.
Every buyer
whose WTP is
< $30 will not.
P
60
5 10 15 20 25 30
31
Which Buyers Get to Consume the Good?
40
CHAPTER 7
34
At Q = 20,
cost of producing
the marginal unit
is $35
P
60
40
Hence, can increase

total surplus
by reducing Q.
20
This is true at any Q

greater than 15.
CHAPTER 7
50
value to consumers
of the marginal unit
is only $20
30
10
Q
0
5 10 15 20 25 30
35
Does Eqm Q Maximize Total Surplus?

At Q = 10,
cost of producing
the marginal unit
is $25
P
60
40
Hence, can increase

total surplus
by increasing Q.
20
This is true at any Q

less than 15.
CHAPTER 7
50
value to consumers
of the marginal unit
is $40
Evaluating the Market Eqm: Summary

The market eqm is efficient:
Eqm Q maximizes total surplus.
Goods produced by the lowest-cost producers.
Consumed by buyers who value them the most.
Govt cannot improve on the market outcome.
30
Laissez faire (French for allow them to do):

the govt should not interfere with the market.
10
Q
0
5 10 15 20 25 30
36
Why Non-Market Allocations Are Usually Bad
CHAPTER 7
Adam Smith and the Invisible Hand

Passages from The Wealth of Nations, 1776
Suppose the allocation of resources were instead

determined by a central planner.
To choose efficient allocation, planner must know
every sellers cost

every buyers WTP
for every good produced in the economy.
This is practically impossible.

Thus, centrally planned economies are never very
efficient.
CHAPTER 7
Adam Smith,
1723-1790
38
Adam Smith and the Invisible Hand
CHAPTER 7
Every individualneither 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
that of the society more effectually than
when he really intends to promote it.
CHAPTER 7
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
we expect our dinner, but from their
regard to their own interest.
39
CONCLUSION
This chapter used welfare economics to
Passages from The Wealth of Nations, 1776
Adam Smith,
1723-1790
37
40
demonstrate one of the Ten Principles:

Markets are usually a good way to
organize economic activity.
But we assumed markets are perfectly competitive.

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
41
CONCLUSION
When markets fail, public policy may remedy the

problem and increase efficiency.
good to buyerstheir willingness to pay for it.
Welfare economics sheds light on market
Consumer surplus is the difference between what
failures and govt policies.
buyers are willing to pay for a good and what they

actually pay.
Despite the possibility of market failure,
On the graph, consumer surplus is the area
the assumptions in this chapter work well in

many markets, and the invisible hand remains
extremely important.
CHAPTER 7
CHAPTER SUMMARY
The height of the D curve reflects the value of the
between P and the D curve.
42
CHAPTER SUMMARY
The height of the S curve is sellers cost of
CHAPTER 7
43
CHAPTER SUMMARY
To measure of societys well-being, we use
producing the good. Sellers are willing to sell if

the price they get is at least as high as their cost.
total surplus, the sum of consumer and producer

surplus.
Producer surplus is the difference between what
Efficiency means that total surplus is maximized,
sellers receive for a good and their cost of

producing it.
that the goods are produced by sellers with lowest

cost, and that they are consumed by buyers who
most value them.
On the graph, producer surplus is the area

between P and the S curve.
Under perfect competition, the market outcome is

efficient. Altering it would reduce total surplus.
CHAPTER 7
44
CHAPTER 7
45

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Consumers, Producers, and the

In this chapter, look for the answers to

What is producer surplus? How is it related to the

Do markets produce a desirable allocation of

2008 Thomson South-Western, all rights reserved

Willingness to Pay (WTP)

A buyers willingness to pay for a good is the

of resources affects economic well-being.

CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

WTP and the Demand Curve

A: Anthony & Flea will buy an iPod,

CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

WTP and the Demand Curve

Q: If price of iPod is $200, who will buy an iPod,

First, we look at the well-being of consumers.

CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

$301 & up nobody

251 300 Flea

176 250 Anthony, Flea

CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

WTP and the Demand Curve

About the Staircase Shape

If there were a huge # of buyers,

CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

WTP and the Demand Curve

The others get no CS because

CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

Fleas CS = $300 260 = $40.

CS and the Demand Curve

CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

Consumer surplus is the amount a buyer is willing

CS and the Demand Curve

CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

Consumer Surplus (CS)

This D curve looks like a staircase

CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

CS and the Demand Curve

CS with Lots of Buyers & a Smooth D Curve

Then his consumer

The demand for shoes

CS with Lots of Buyers & a Smooth D Curve

CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

How a Higher Price Reduces CS

Two reasons for the

CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

Cost and the Supply Curve

CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

The demand for shoes

CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

CS is the area b/w

up to produce a good (i.e., opportunity cost).

Includes cost of all resources used to produce

Example: Costs of 3 sellers in the lawn-cutting

A seller will only produce and

CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

Cost and the Supply Curve

Cost and the Supply Curve

Derive the supply schedule

Producer surplus (PS):

CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS

the marginal sellers

Total PS equals the