Consumers, Producers and the Efficiency of Markets
To begin the study of welfare economics we must look at the benefits buyers receive from participating in
Welfare Economics: The study of how the allocation of resources affects economic well being.
Willingness to Pay
Willingness to pay: the maximum amount that a buyer will pay for a good
This determines the buyer’s consumer surplus for the good.
Consumer Surplus: A buyer’s willingness to pay minus the amount the buyer actually pays.
The greater the gap between the actual price and the price the buyer is willing to pay, the greater the
consumer surplus is and the more beneficial it is to participate in the market.
Using the Demand Curve to Measure Consumer Surplus
For an individuals consumer surplus:
You subtract the price of the good from the buyer’s willingness to pay
For the entire market’s consumer surplus:
The area below the demand curve and above the price measures the consumer surplus.
How a Lower Price Raises Consumer Surplus
When the price goes down the consumer surplus goes up
How much can be calculated by calculating the difference in area between the original triangle and the
(See Page 150, Figure 7.3 for clearer example) What Does Consumer Surplus Measure?
The goal in developing the concept of consumer surplus is to be able to make normative judgments about
the desirability of market outcomes.
If policy makers choose to favor the best interest of the buyer’s they will wish to create a higher consumer
In most markets, consumer surplus does reflect the economic wellbeing.
The benefits sellers receive from participating in a market
Cost and Willingness to Sell
The sellers willingness to sell depends on the cost it is to do the job or produce the good.
Cost: the value of everything a seller must give up to produce the good.
The seller will take no less than the cost of everything they gave up to produce the good.
The seller would be happy to take more (increasing their producer surplus)
Producer Surplus: the amount a seller is paid for a good minus the seller’s cost
Using the Supply Curve to Measure Producer Surplus
To create the graph you use the cost of the sellers
The area above the supply curve and below the price is equal to the producer surplus.
The height of the supply curve measures sellers’ costs
The difference between the price and the cost of production is each seller’s producer surplus. How a Higher Price Raises Producer Surplus
Beginning with triangle ABC
The original sellers benefit because they are gaining more for their service
Their gain can be measured by calculating the area of rectangle BCDE
The new sellers who join the market also benefit because of the higher price
Their producer surplus can be measured by calculating the area of triangle CEF
The entire increase in producer surplus as a result of the new price can be calculated by the area of DBFC
(See page 154 Figure 7.6 for a clearer example)
Using Consumer and producer surplus we can see if the allocation of resources determined by free
markets is in any way desirable.
The Benevolent Social Planner
The benevolent social planner is a new “character” who wishes to maximize the economic wellbeing of
everyone in society.
In order to do this one must first decide how to measure the economic well being of society.
One possible measure is the sum of the consumer surplus and producer surplus which we call the total
Total Surplus = Value to Buyers – Cost to sellers
Efficiency: the property of a resource allocation of maximizing the total surplus received by all members of
If an allocation does not maximize the total surplus, it is because the seller used does not have the lowest
cost, and the buyer used does not have the highest willingness to pay.
Equity: the fairness of the distribution of wellbeing among the members of society. the social planner might also care about how fairly the good is distributed.
Evaluating the Market Equilibrium
1. Free markets allocate the supply of goods to the buyers who value them most, as decided by their
willingness to pay.
2. Free markets allocate the demand for good to the suppliers who have the lowest costs.
3. Free markets produce the quantity of goods that maximizes the consumer surplus and the producer
surplus (the total surplus)
* The equilibrium quantity and price maximizes the total surplus therefor there is no need to intervene with
the free market. Application: The Cost of Taxation 10/16/2013
The Deadweight Loss of Taxation
A tax on the good causes the size of the market to shrink
Deadweight Loss: The fall in total surplus that results from a market distortion such as tax.