Economics Chapter 7
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 of resources affects economic well-being.
First, we look at the well-being of consumers.
Willingness to Pay (WTP)
A buyer’s 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.
WTP and the Demand Curve
Q: If price of iPod is $200, who will buy an iPod, and what is
A: Anthony & Flea will buy an iPod, Chad & John will not.
Hence, Q = 2
when P = $200.
Derive the demand schedule: WTP and the Demand Curve Consumer Surplus (CS)
Consumer surplus is the amount a buyer is willing to pay minus the amount the buyer actually pays:
CS = WTP – P
Suppose P = $260.
Flea’s CS = $300 – 260 = $40.
The others get no CS because they do not buy an iPod at this price.
Total CS = $40. CS with Lots of Buyers & a Smooth D curve
How a higher Price Reduces CS
Exercise 1 Consumer Surplus
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
A. At Q = 10, marginal buyer’s WTP is $30.
B. CS = ½ x 10 x $10 = $50
C. CS for the additional buyers = ½ x 10 x $10 = $50
D. Increase in CS on initial 10 units = 10 x $10 = $100 Cost and the Supply Curve
Cost is the value of everything a seller must give up to produce a good (i.e., opportunity cost).
Includes cost of all resources used to produce good, including value of the seller’s time.
Example: Costs of 3 sellers in the lawn-cutting business.
A seller will produce and sell the good/service only if the price exceeds his or
Hence, cost is a measure of willingness to sell.
Derive the supply schedule from the
cost data: Exercise 2
A. Find marginal seller’s cost at Q = 10.
B. Find total 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
A. At Q = 10, marginal cost = $20
A. B. PS = ½ x 10 x $20 = $100 P rises to $30.
B. PS on additional units = ½ x 5 x $10 = $25
C. Increase in PS on initial 10 units = 10 x $10 = $100 CS, PS, and Total Surplus
CS = (value to buyers) – (amount paid by buyers)
= buyers’ gains from participating in the market
PS = (amount received by sellers) – (cost to sellers)
= sellers’ gains from participating in the market
Total surplus = CS + PS
= total gains from trade in a market
= (value to buyers) – (cost to sellers)
The Market’s Allocation of Resources
In a market economy, the allocation of resources
is decentralized, determined by the interactions
of many self-interested buyers and sellers.
Is the market’s allocation of resources desirable? Or would a different allocation of resources
make society better off?
To answer this, we use total surplus as a measure of society’s well-being, and we consider
whether the market’s allocation is efficient.
o (Policymakers also care about equality, though are focus here is on efficiency.)
An allocation of resources is efficient if it maximizes total surplus. Efficiency means:
The goods are consumed by the buyers who value them