Market Efficiency and Welfare
7 c h a p t e r
In earlier chapters, we saw how the market forces of supply and demand allocate society’s scarce resources.
However, we did not discuss whether or not this outcome was desirable and to whom. Is the price and output that results from the equilibrium of supply and demand right from society’s standpoint?
Using the tools of consumer and producer surplus, we can demonstrate the efficiency of a competitive market. In other words, we can show that the equilibrium price and quantity in a competitive market maximizes the economic welfare of consumers and producers. We can also use the tools of consumer and producer surplus to study the welfare effects of government policy—rent controls, taxes, and agricultural support prices. Welfare to economists does not mean a government payment to the poor; rather, it is a way that we measure the impact of a policy on a particular group—like consumers or producers. By calculating the changes in producer and consumer surplus that result from government intervention, we can measure the impact of such policies on buyers and sellers. For example, economists and policymakers might want to know how much a consumer or producer might benefit or be harmed by a tax or a subsidy that alters the equilibrium price and quantity.
CONSUMER SURPLUS
In a competitive market, consumers and producers buy and sell at the market equilibrium price. However, some consumers will be willing and able to pay more for the good than they have to. That is, what a consumer actually pays for a unit of a good is usually less than the amount she is willing to pay.
For example, you would be willing and able to pay far more than the market price for a rope ladder to get out of a burning building. You would be willing to pay more than the market price for a tank of gasoline if you had run out of gas on a desolate highway in the desert. Consumer surplus is the monetary difference between the amount a consumer is willing and able to pay for an additional unit of a good and what the consumer actually pays—the market price. Consumer surplus for the whole market is the sum of all the individual consumer surpluses for those consumers who have purchased the good.
MARGINAL WILLINGNESS TO PAY FALLS AS MORE IS CONSUMED
Suppose it is a very hot day and iced tea is going for $1 per glass, but a consumer is willing to pay $4 for the first glass, $2 for the second glass, and $0.50 for the third glass, reflecting the law of demand.
How much consumer surplus will this consumer receive?
First, it is important to note the general fact that if the consumer is a buyer of several units of a
Consumer Surplus and Producer Surplus
s e c t i o n
7.1
_ What is consumer surplus?
_ What is producer surplus?
_ How do we measure the total gains from trade?
126 CHAPTER SEVEN | Market Efficiency and Welfare
Imagine it is 115 degrees in the shade. Do you think you would get more consumer surplus from your first glass of iced tea than you would from a fifth glass?
© PhotoDisc/Getty One Images
good, the earlier units will have greater marginal value and therefore create more consumer surplus, because marginal willingness to pay falls as greater quantities are consumed in any period (the law of diminishing marginal utility). This is demonstrated by the consumer’s willingness to pay $4 and $2 successively for the first two glasses of iced tea. Thus, the consumer will receive $3 of consumer surplus for the first glass ($4 2 $1) and $1 of consumer surplus for the second glass ($2 2 $1), for a total of $4, as seen in Exhibit 1. The consumer will not be willing to purchase the third glass, because it would provide less value than its price warrants ($0.50 versus $1.00) and reduce consumer surplus as a result.
In Exhibit 2, consumer surplus is shown as the area under the market demand curve and above the market price (area A). Areas A and B together represent
total willingness to pay for Q units of the good, while area B is called the actual expenditure,
which is the amount the consumer is required to pay for that quantity (P 3 Q). The difference is consumer surplus, the shaded area A.
PRICE CHANGES AND CHANGES IN CONSUMER SURPLUS
Imagine that the price of your favorite beverage fell because of an increase in supply. Wouldn’t you feel better off? An increase in supply and a lower price will increase your consumer surplus for each unit you were already consuming and will also increase your consumer surplus from additional purchases at the lower price. Conversely, a decrease in supply and increase in price will lower your consumer surplus.
Exhibit 3 shows the gain in consumer surplus associated with say a technological advance that shifts the supply curve to the right. As a result,
Consumer Surplus and Producer Surplus 127
2 1 3
DICED TEA
Price of Iced Tea (per glass) Quantity of Iced Tea (by glass)
0 $4 $3 $3 $2 $1 $1
Consumer surplus _
$3 _ $1 _ $4 Maximum price willing to pay for 1st glass Market price
$ .50
Maximum price willing to pay for 2nd glass Maximum price willing to pay for 3rd glass
Consumer Surplus for Iced Tea
SECTION 7.1
EXHIBIT 1
The consumer receives $3 of consumer surplus for the first unit and $1 of consumer surplus for the second unit.
Q P Demand
Price Quantity
0
A B Consumer surplus in the market Market price Marginal willingness to pay for last unit (Actual Expenditure)
Consumer Surplus
EXHIBIT 2
The monetary difference between what a buyer actually pays (the market price) and what a buyer is willing and able to pay is called consumer surplus. It is represented by the shaded area A.
Q1 Q2
P1
Demand
0 P2
S2
C B A S1
D
Q1 can now be purchased at a lower price A lower price makes it advantageous for buyers to expand their purchases
The Impact of an Increase in Supply on Consumer Surplus
EXHIBIT 3
As a result of the increase in supply, the price falls from P1 to
P2. The initial consumer surplus at P1 is the area P1AB. The increase in the consumer surplus from the fall in price is P1BCP2.
equilibrium price falls (from P1 to P2) and quantity rises (from Q1 to Q2). Consumer surplus then increases from area P1AB to area P2AC, or a gain in consumer surplus of P1BCP2. The increase in consumer surplus has two parts. First, there is an increase in consumer surplus because Q1 can now be purchased at a lower price; this amount of additional consumer surplus is illustrated by area
P1BDP2 in Exhibit 3. Second, the lower price makes it advantageous for buyers to expand their purchases from Q1 to Q2. The net benefit to buyers from expanding their consumption from Q1 to Q2
is illustrated by area BCD.
PRODUCER SURPLUS
As we have just seen, the difference between what a consumer would be willing and able to pay for a quantity of a good and what a consumer actually has to pay is called consumer surplus. The parallel concept for producers is called producer surplus.
Producer surplus is the difference between what a producer is paid for a good and the cost of producing one unit of that good. Because some units can be produced at a cost that is lower than the market price, the seller receives a surplus, or a net benefit, from producing those units. For example, in Exhibit 4, the market price is $5. Say the firm’s cost is $2 for the first unit; $3 for the second unit; $4 for the third unit; and $5 for the fourth unit. Because producer surplus for a particular unit is the difference between the market price and the seller’s cost of producing that unit, producer surplus would be as follows: The first unit would yield $3, the second unit would yield $2, the third unit would yield $1, and the fourth unit would add no more to producer surplus, as the market price equals the seller’s cost.
For the market, producer surplus is obtained by summing all the producer surplus of all the sellers— the area above the market supply curve and below the market price. Producer surplus is a measurement of how much sellers gain from trading in the market.
Suppose there is an increase in demand and the market price rises, say from P1 to P2; the seller now receives a higher price per unit, so additional producer surplus is generated. In Exhibit 5, we see the additions to producer surplus. Part of the added surplus (area P1DBP2) is due to a higher price for the quantity already being produced (up to Q1) and part (area DCB) is due to the expansion of output made profitable by the higher price (from Q1 to Q2).
128 CHAPTER SEVEN | Market Efficiency and Welfare
$5 4 3 2 1 0 1 2 3
$3
4 Supply Demand
Quantity Price
$1 $2 Producer surplus in the market
Producer Surplus
EXHIBIT 4
For each unit, producer surplus measures the difference between what sellers are paid and the seller’s costs of production.
The sum of the producer surplus is illustrated by the shaded area above the supply curve and below the market price.
Supply Q1
D1
D2
Q2
A B C D
A higher price for quantity already being produced Expansion of output from Q1 to Q2 made profitable because of higher price
The Impact of an Increase in Demand on Producer Surplus
EXHIBIT 5
A higher market price due to an increase in demand will increase total producer surplus. The initial producer surplus at P1
is the area ABP1. The increase in producer surplus from the higher price is area P2CBP1.
MARKET EFFICIENCY AND PRODUCER AND CONSUMER SURPLUS
With the tools of consumer and producer surplus, we can better analyze the total gains from exchange.
The demand curve represents a collection of maximum prices that consumers are willing and able to pay for additional quantities of a good or service. The supply curve represents a collection of minimum prices that suppliers require to be willing and able to supply each additional unit of a good or service, as seen in Exhibit 6. For example, for the first unit of output, the buyer is willing to pay up to $7, and the seller would have to receive at least $1 to produce that unit. However, the equilibrium price is $4, as indicated by the intersection of the supply and demand curves. It is clear that the two would gain from getting together and trading that unit because the consumer would receive $3 of consumer surplus ($7 2 $4) and the producer would receive $3 of producer surplus ($4 2 $1). Both would also benefit from trading the second and third units of output—in fact, both would benefit from trading every unit up to the market equilibrium output.
That is, the buyer purchases each good, except for the very last unit, for less than the maximum amount she would have been willing to pay; the seller receives for the good, except for the last unit, more than the minimum amount that he would have been willing to supply. Once the equilibrium output is reached at the equilibrium price, all the mutually beneficial trade opportunities between the supplier and the demander will have taken place, and the sum of consumer surplus and producer surplus is maximized. Both buyer and seller are better off from each of the units traded than they would have been if they had not exchanged them.
It is important to recognize that, in this case, the total welfare gains to the economy from trade in this good is the sum of the consumer and producer surpluses created. That is, consumers benefit from additional amounts of consumer surplus, and producers benefit from additional amounts of producer surplus. Improvements in welfare come from additions to both consumer and producer surpluses.
In competitive markets, where there are large numbers of buyers and sellers, at the market equilibrium price and quantity, the net gains to society are as large as possible.
Why would it be inefficient to produce only 3 million units? The demand curve in Exhibit 6 indicates that the buyer is willing to pay $5 for the 3 millionth unit. The supply curve shows that it only costs the seller $3 to produce that unit. That is, as long as the buyer values the extra output by more than it cost to produce that unit, total welfare would increase by expanding output. In fact, if output is expanded from 3 million units to 4 million units, total welfare (the sum of consumer and producer surplus) will increase by area AEB in Exhibit 6.
What if 5 million units are produced? The demand curve shows that the buyer is only willing to pay $3 for the 5 millionth unit. However, the supply curve shows that it would cost $5.50 to produce that 5 millionth unit. Thus, increasing output beyond equilibrium decreases total welfare because the cost of producing this extra output is greater than the value the buyer places on it. If output is reduced from 5 million units to 4 million units, total welfare will increase by area ECD in Exhibit 6.
Not producing the efficient level of output, in this case 4 million units, leads to what economists call a deadweight loss. A deadweight loss will often result in a reduction of both consumer and producer surpluses—it is the net loss of total surplus that results from the misallocation of resources.
Consumer Surplus and Producer Surplus 129
5 4 3 $8 7 6 2 1
CS PS CS PS CS PS
Supply Demand 0 1 2
Quantity (Millions of units/yr) Price
3 4 5 B C D A E
Consumer and Producer Surplus
EXHIBIT 6
Increasing output beyond the competitive equilibrium output, 4 million units, decreases welfare because the cost of producing this extra output exceeds the value the buyer places on it— producing 5 million units rather than 4 million units leads to a deadweight loss of area ECD. Reducing output below the competitive equilibrium output level, 4 million units, reduces total welfare because the buyer values the extra output by more than it costs to produce that output—producing 3 million units rather than 4 million units leads to a deadweight loss of area EAB.
130 CHAPTER SEVEN | Market Efficiency and Welfare
In America, retailers make 25% of their yearly sales and 60% of their profits between Thanksgiving and Christmas. Even so, economists find something to worry about in the nature of the purchase being made.
Much of the holiday spending is on gifts for others. At the simplest level, giving gifts involves the giver thinking of something that the recipient would like—he tries to guess her preferences, as economists say—and then buying the gift and delivering it. Yet this guessing of preferences is no mean feat; indeed, it is often done badly. Every year, ties go unworn and books unread.
And even if a gift is enjoyed, it may not be what the recipient would have bought had she spent the money herself.
Intrigued by this mismatch between wants and gifts, in 1993 Joel Waldfogel, then an economist at Yale University, sought to establish the disparity in dollar terms. In a paper that has proved seminal in the literature on the issue, he asked students two questions at the end of the holiday season: first, estimate the total amount paid (by givers) for all holiday gifts you received; second, apart from sentimental value of the items, if you did not have them, how much would you be willing to pay to get them? His results were gloomy: on average, a gift was valued by the recipient well below the price paid by the giver.
The most conservative estimate put the average receiver’s valuation at 90% of the buying price. The missing 10% is what economists call a deadweight loss: a waste of resources that could be averted without making anyone worse off. In other words, if the giver gave the cash value of the purchase instead of the gift itself, the recipient could then buy what she really wants, and be better off for no extra cost.
Perhaps not surprisingly, the most effective gifts (those with the smallest deadweight loss) were those from close friends and relations, while non-cash gifts from extended family were the least efficient. As the age difference between giver and recipient grew, so did the inefficiency. All of which suggests what many grandparents know: when buying gifts for someone with largely unknown preferences, the best present is one that is totally flexible (cash) or very flexible (gift vouchers).
If the results are generalized, a waste of one dollar in ten represents a huge aggregate loss to society. It suggests that in America, where givers spend $40 billion on Christmas gifts, $4 billion is being lost annually in the process of gift giving. Add in birthdays, weddings and non-Christian occasions and the figure would balloon. So should economists advocate an end to gift giving, or at least press for money to become the gift of choice?
SENTIMENTAL VALUE
There are a number of reason to think not. First, recipients may not know their own preferences very well. Some of the best gifts, after all, are the unexpected items that you would never have thought of buying but turn out to be especially well picked.
And preferences can change. So by giving a jazz CD, for example, the giver may be encouraging the recipient to enjoy something that was shunned before. This, and a desire to build skills, is presumably the hope held by the many parents who ignore their children’s pleas for video games and but give them books instead.
Second, the giver may have access to items—because of travel or an employee discount, for example—that the recipient does not know existed, cannot buy, or can only buy at a higher price. Finally, there are items that a recipient would like to receive but not purchase. If someone else buys them, however, they can be enjoyed guilt-free. This might explain the high volume of chocolate that changes hands over the holidays.
But there is a more powerful argument for gift giving, deliberately ignored by most surveys. Gift giving, some economists think, is a process that adds value to an item over and above what it would otherwise be worth to the recipient. Intuition backs this up, of course. A gift’s worth is not only a function of its price but also of the giver and the circumstances in which it is given.
Hence, a wedding ring is more valuable to its owner than to a jeweler, and the imprint of a child’s hand on dried clay is priceless to a loving grandparent. Moreover, not only can gift giving add value for the recipient, but it can be fun for the giver, too. It is good, in other words, to give as well as to receive.
The lesson then, for gift givers? Try hard to guess the preferences of each person on your list and then choose a gift that will have high sentimental value. As economists have studied hard to tell you, it’s the thought that counts.
SOURCE: The Economist (online edition), December 20, 2001. http://www.
economist.com/PrinterFriendly.cfm?Story_ID5885748.
IS SANTA A DEADWEIGHT LOSS?
In The NEWS
In the last section we used the tools of consumer and producer surplus to measure the efficiency of a competitive market—that is, how the equilibrium price and quantity in a competitive market lead to the maximization of aggregate welfare (for both buyers and sellers). Now we can use the same tools, consumer and producer surplus, to measure the welfare effects of various government programs— taxes and price controls. When economists use the term welfare effects of a government policy, they are referring to the gains and losses associated with government intervention. This should not be confused with the way we commonly use the term referring to a welfare recipient who is getting aid from the government.
USING CONSUMER AND PRODUCER SURPLUS TO FIND THE WELFARE EFFECTS OF A TAX
To simplify the explanation of elasticity and the tax incidence, we will not complicate the illustration by shifting the supply curve (tax levied on sellers) or demand curve (tax levied on buyers), as we did in Section 6.3. We will simply show the result a tax must cause. The tax is illustrated by the vertical distance between the supply and demand curve at the new after-tax output—shown as the bold vertical line in Exhibit 1. After the tax, the buyers pay a higher price, PB, and the sellers receive a lower price, PS, and the equilibrium quantity of the good (both bought and sold) falls from Q1 to Q2.
The Welfare Effects of Taxes, Subsidies, and Price Controls 131
1. The difference between how much a consumer is willing and able to pay and how much a consumer has to pay for a unit of the good is called consumer surplus.
2. An increase in supply will lead to a lower price and an increase in consumer surplus; a decrease in supply will lead to a higher price and a decrease in consumer surplus.
3. Producer surplus is the difference between what a producer is paid for a good and the cost of producing that good.
4. An increase in demand will lead to a higher market price and an increase in producer surplus; a decrease in demand will lead to a lower market price and a decrease in producer surplus.
5. Total welfare gains from trade to the economy can be measured by the sum of consumer and producer surplus.
1. What is consumer surplus?
2. Why do the first units consumed at a given price add more consumer surplus than the last units consumed?
3. Why does a decrease in a good’s price increase the consumer surplus from consumption of that good?
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