Consumers, Producers, and the Efficiency of Markets

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# Consumers, Producers, and the Efficiency of Markets
## Chapter 7
### Hussain Hadah
### University of Houston | 24 February 2022

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# Table of contents

1. [Introduction](#intro)

2. [Consumer Surplus](#sec1)

3. [Producer Surplus](#sec2)

4. [Market Efficiency](#sec3)

5. [Conclusion](#sec4)

6. [Problems and Applications](#sec5)

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# Introduction

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# The Invisible Hand

- So far in this class, our analysis has been _positive_ (what is) rather than _normative_ (what should be)

- In this chapter we will discuss <span style="color:red;"> _welfare economics_</span>

- <span style="color:red;"> _Welfare economics_</span> is the study of how the allocation of resources affects economic well-being

- We will look at how buyers and sellers benefit from engaging in market transactions

- We will also examine how society benefits

- We will conclude that in any market, the total benefits received by buyers and sellers are maximized at equilibrium

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name: sec1

# Consumer Surplus

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# Willingness to pay

- <span style="color:red;"> _Willingness to pay_</span> is the maximum amount a buyer is willing to giveup in return of a good or a service

- Buyers will enter a transaction if the price of a good is lower than their <span style="color:red;"> _willingness to pay_</span>

- Buyers will refuse to participate in a transaction if the price of a good is higher than their <span style="color:red;"> _willingness to pay_</span>

- Buyers will be indifferent about buying the good if the price is equal to their <span style="color:red;"> _willingness to pay_</span> (they are equally as happy buying the good or keeping the money)

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# Example

<h3>
  <ul>
  <li>You have a ball signed by James Harden</li>
  <li>You don't want to keep the ball because Harden left the Rockets</li>
  <li>You start an auction on eBay</li>
  <li>4 people are willing to buy the ball</li>
  <li>The max willingness to pay for each potential buyer is presented in the next table</li>
  <li>You start the bidding at $10</li>
  <li>What will happen?</li>
  </ul>
</h3>

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# Max willingness to pay for each buyer

--
<h4>
  <ul>
  <li>The bidding begins at $10 which is lower than the max willingness to pay for all potential buyers</li>
  <li>The price of the ball will rise quickly</li>
  <li>Gaga will keep raising her bids until she reaches $50</li>
  <li>Rihanna will keep raising her bids until she reaches $70</li>
  <li>Carrie will keep raising her bids until she reaches $80</li>
  </ul>
</h4>

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<h1 style="font-size:32px">Max willingness to pay for each buyer (cont.)</h1>
</br>

--
<h4>
  <ul>
  <li>Now, the price of the ball is $80, which is still less than Taylor's max</li>
  <li>So Taylor will put an offer at $80, that's higher than the max of the three other bidders</li>
  <li>The last bid would be $80, and that will be the price of the ball</li>
  <li>The ball went to the person that values it the most</li>
  <li>Taylor was willing to pay $100, but got the ball at a bargain at $80</li>
  </ul>
</h4>

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<h1 style="font-size:32px">Max willingness to pay for each buyer (cont.)</h1>
</br>

<img src="images/image1.png" width="100%" height="100%" style="display: block; margin: auto;" />
<h4>
  <ul>
  <li>The difference between the max willingness to pay and the price a consumer paid is called <span style="color:red;">consumer surplus</span></li>
  <li>Taylor's <span style="color:red;">consumer surplus</span> is $20</li>
  </ul>
</h4>
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# Same example but there are 3 balls

<h4>
  <ul>
  <li>Assume the three balls will be sold at the same price</li>
  </br>
  <li>No one is interested in buying more than one</li>
  </br>
  <li>The bidding will stop when Rihanna, Carrie and Taylor bid $50</li>
  </br>
  <li>Taylor's <span style="color:red;">consumer surplus</span> is $50</li>
  </br>
  <li>Carrie's <span style="color:red;">consumer surplus</span> is $30</li>
  </br>
  <li>Rihanna's <span style="color:red;">consumer surplus</span> is $20</li>
  </br>
  <li>Total <span style="color:red;">consumer surplus</span> in the market is $100</li>
  </ul>
</h4>

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# Measuring consumer surplus

### How to measure consumer surplus using the demand curve?

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<h1 style="font-size:32px">Consumer surplus when the price is $80 and $70</h1>
</br>

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# Prices and consumer surplus

### Consumers always want to have lower prices because it increases their consumer surplus

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# What does consumer surplus measure?

### Can consumer surplus be a good measure of economic well-being?

### If Congress is trying to pass a law, should policymakers consider consumer surplus?

#### Since consumer surplus is the amount that buyers perceive they are benefiting from, it is a good measure of well-being in many cases

#### A case where consumer surplus is not a good measure of well-being is the market for illicit drugs. In this case, society does not perceive consumer surplus as a measure of well-being

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# Producer Surplus

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# Cost and willingness to sell

- Let's say you want to paint your house

- There are four sellers for this service: Vincent, Claude, Pablo and Andy

- Each painter will work if the offer was attractive to them

- A painter will take a job if the offer exceeds the cost of the job

- <span style="color:red;"> _Willingness to sell_</span> is the lowest amount a person is willing to receive for a good or a service

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# The painters' <span style="color:red;"> _Willingness to sell_</span>
<img src="images/image5.png" width="80%" height="80%" style="display: block; margin: auto;" />

- The price of the service will keep falling until $600

- At $600, Vincent, Claude and Pablo will not take the job

- At $600, Andy will be happy to take the job

- Andy's <span style="color:red;"> _producer surplus_</span> is $100

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<h1 style="font-size:32px">Using the supply curve to measure producer surplus</h1>
</br>

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# Producer surplus at $600 & $800

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# Prices & producer surplus

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# Market Efficiency

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# The benevolent social planner

- To understand the market outcomes, let's say there is a benevolent social planner

- The benevolent social planner knows everything, powerful and well-intentioned dictator (What Plato called the philosopher king)

- The planner wants to maximize the well-being of society

- Should she leave buyers and sellers at the market equilibrium?

- Should she increase the economic well-being by altering the market?

- To answer the two questions we need a measure of societal economic well-being

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# The benevolent social planner (cont.)
- One such measure is the <span style="color:red;"> _total surplus_</span>

$$
`\begin{align}
\text{Consumer Surplus} &=  \text{Value to buyers} - \text{amount paid by buyers} \\
\text{Producer Surplus} &=  \text{Amount received by sellers} - \text{Cost to sellers} \\
\text{Total Surplus} &=  \text{Consumer Surplus} + \text{Producer Surplus}
\end{align}`
$$
- If allocation of resources maximizes total surplus, the outcome is <span style="color:red;"> _efficient_</span>

- We might also care about <span style="color:red;"> _equality_</span> and whether buyers and sellers in the market receive similar level of economic well-being

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# Evaluating Market Equilibrium

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# Some insights

### 1. Free markets allocate the supply of goods to the buyers who value them most, as measured by their willingness to pay

### 2. Free markets allocate the demand for goods to the sellers who can produce them at the lowest cost

### 3. Free markets produce the number of goods that maximizes the sum of consumer and producer surplus

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# Efficiency of the equilibrium quantity

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# Conclusion

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# A word of warning

### - We made several assumptions to include that markets are efficient

### - We assumed that markets are perfectly competitive and that market outcomes only matter to buyers and sellers

### - When these assumptions do not hold, and they do not hold most of the time, the conclusion that at equilibrium the market is efficient no longer holds

### - In reality, some markets are monopolistic

### - Market transactions also matter to third parties that aren't the buyers and sellers (we call this externalities)

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# Problems and Applications

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# Question 1

<h3>Melissa buys an iPhone for 240 and gets consumer surplus of 160</h3>

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#### What is her willingness to pay?</li>
    
--

- Willingness to pay is the sum of the price paid and consumer surplus. Therefore, Melissa’s willingness to pay is 400 = 240 + 160
  
    
--

#### If she had bought the iPhone on sale for 180, what would her consumer surplus have been?

- Her consumer surplus at a price of 180 would be 400 − 
180 = 220
  
    
--

#### If the price of an iPhone were 500, what would her consumer surplus have been?

- If the price of an iPhone was 500, Melissa would not have purchased one because the price is greater than her willingness to pay. Therefore, she would receive no consumer surplus.

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# Question 2

#### An early freeze in California sours the lemon crop. Explain what happens to consumer surplus in the market for lemons. Explain what happens to consumer surplus in the market for lemonade. Illustrate your answers with diagrams.

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# Question 3

#### Suppose the demand for French bread rises. Explain what happens to producer surplus in the market for French bread. Explain what happens to producer surplus in the market for flour. Illustrate your answers with diagrams.

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# Question 4

#### It is a hot day, and Bert is thirsty. Here is the value he places on each bottle of water:

$$
`\begin{align}
\text{Value of first bottle} &=  7 \\
\text{Value of second bottle} &=  5 \\
\text{Value of third bottle} &=  3 \\
\text{Value of fourth bottle} &=  1 \\
\end{align}`
$$

##### From this information, derive Bert’s demand schedule. Graph his demand curve for bottled water.

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# Question 4

#### If the price of a bottle of water is $4, how many bottles does Bert buy? How much consumer surplus does Bert get from his purchases? Show Bert’s consumer surplus in your graph.

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# Question 4

#### If the price falls to $2, how does quantity demanded change? How does Bert’s consumer surplus change? Show these changes in your graph.

---
# Question 5

#### Ernie owns a water pump. Because pumping large amounts of water is harder than pumping small amounts, the cost of producing a bottle of water rises as he pumps more. Here is the cost he incurs to produce each bottle of water:

$$
`\begin{align}
\text{Cost of first bottle} &=  1 \\
\text{Cost of second bottle} &=  3 \\
\text{Cost of third bottle} &=  5 \\
\text{Cost of fourth bottle} &=  7 \\
\end{align}`
$$

##### From this information, derive Ernie’s supply schedule. Graph his supply curve for bottled water.

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# Question 5

##### If the price of a bottle of water is $4, how many bottles does Ernie produce and sell? How much producer surplus does Ernie get from these sales? Show Ernie’s producer surplus in your graph.

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# Question 5

##### If the price rises to $6, how does quantity supplied change? How does Ernie’s producer surplus change? Show these changes in your graph.

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# Question 6

#### Consider a market in which Bert from problem 4 is the buyer and Ernie from problem 5 is the seller.

#### Use Ernie’s supply schedule and Bert’s demand schedule to find the quantity supplied and quantity demanded at prices of $2, $4, and $6. Which of these prices brings supply and demand into equilibrium?

--
</br>

| Price      | Quantity Supplied | Quantity Demanded |
| ----------- | ----------- |----------- |
| $2      | 1       |3       |
| $4   | 2        |2        |
| $6   | 3        |1        |

---
# Question 6

#### Consider a market in which Bert from problem 4 is the buyer and Ernie from problem 5 is the seller.

#### What are consumer surplus, producer surplus, and total surplus in this equilibrium?

</br>

| Price      | Quantity Supplied | Quantity Demanded |
| ----------- | ----------- |----------- |
| $2      | 1       |3       |
| $4   | 2        |2        |
| $6   | 3        |1        |

#### At a price of $4, consumer surplus is $4 and producer surplus is $4, as shown in Problems 3 and 4 above. Total surplus is $4 + $4 = $8.

---
# Question 6

#### Consider a market in which Bert from problem 4 is the buyer and Ernie from problem 5 is the seller.

#### If Ernie produced and Bert consumed one fewer bottle of water, what would happen to total surplus?

</br>

| Price      | Quantity Supplied | Quantity Demanded |
| ----------- | ----------- |----------- |
| $2      | 1       |3       |
| $4   | 2        |2        |
| $6   | 3        |1        |

#### If Ernie produced one less bottle, his producer surplus would decline to $3, as shown in Problem 4 above. If Bert consumed one less bottle, his consumer surplus would decline to $3, as shown in Problem 3 above. So total surplus would decline to $3 + $3 = $6.

---
# Question 6

#### Consider a market in which Bert from problem 4 is the buyer and Ernie from problem 5 is the seller.

#### If Ernie produced and Bert consumed one additional bottle of water, what would happen to total surplus?

</br>

| Price      | Quantity Supplied | Quantity Demanded |
| ----------- | ----------- |----------- |
| $2      | 1       |3       |
| $4   | 2        |2        |
| $6   | 3        |1        |

#### If Ernie produced one additional bottle of water, his cost would be $5, but the price is only $4, so his producer surplus would decline by $1. If Bert consumed one additional bottle of water, his value would be $3, but the price is $4, so his consumer surplus would decline by $1. So total surplus declines by $1 + $1 = $2.

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# Question 7

#### The cost of producing flat-screen TVs has fallen over the past decade. Let’s consider some implications of this fact.

##### Draw a supply-and-demand diagram to show the effect of falling production costs on the price and quantity of flat-screen TVs sold.

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<img src="images/ques7.png" width="70%" height="70%" style="display: block; margin: auto;" />

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# Question 7

#### The cost of producing flat-screen TVs has fallen over the past decade. Let’s consider some implications of this fact.

##### In your diagram, show what happens to consumer surplus and producer surplus.

--
<img src="images/ques7.png" width="70%" height="70%" style="display: block; margin: auto;" />

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# Question 7

#### The cost of producing flat-screen TVs has fallen over the past decade. Let’s consider some implications of this fact.

##### Suppose the supply of flat-screen TVs is very elastic. Who benefits most from falling production costs—consumers or producers of these TVs?

--
<img src="images/ques7c.png" width="70%" height="70%" style="display: block; margin: auto;" />

---
# Question 8

#### There are four consumers willing to pay the following amounts for haircuts:

- Gloria 35, Jay 10, Claire 40, Phil 25

#### There are four haircutting businesses with the following costs:

- Firm A 15, Firm B 30, Firm C 20, Firm D 10

#### Each firm has the capacity to produce only one haircut. To achieve efficiency, how many haircuts should be given? Which businesses should cut hair and which consumers should have their hair cut? How large is the maximum possible total surplus?

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# Question 9

#### One of the largest changes in the economy over the past several decades is that technological advances have reduced the cost of making computers.

#### Draw a supply-and-demand diagram to show what happened to price, quantity, consumer surplus, and producer surplus in the market for computers.

--
<img src="images/ques9a.png" width="50%" height="50%" style="display: block; margin: auto;" />

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# Question 9

#### One of the largest changes in the economy over the past several decades is that technological advances have reduced the cost of making computers.

#### Forty years ago, students used typewriters to prepare papers for their classes; today they use computers. Does that make computers and typewriters complements or substitutes? Use a supply-and-demand diagram to show what happened to price, quantity, consumer surplus, and producer surplus in the market for typewriters. Should typewriter producers have been happy or sad about the technological advance in computers?

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<img src="images/ques9b.png" width="40%" height="40%" style="display: block; margin: auto;" />

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# Question 9

#### One of the largest changes in the economy over the past several decades is that technological advances have reduced the cost of making computers.

#### Are computers and software complements or substitutes? Draw a supply-and-demand diagram to show what happened to price, quantity, consumer surplus, and producer surplus in the market for software. Should software producers have been happy or sad about the technological advance in computers?

--
<img src="images/ques9c.png" width="40%" height="40%" style="display: block; margin: auto;" />