Words to keep in mind:
Welfare Economics: the study of how the economic well being is affected by the allocation of resources.
Willingness to pay: the maximum amount that a buy is willing to pay for a good.
Consumer Surplus: Buyer's willingness to pay minus the buyer's actual payment.
Cost: The value a seller must give up in order to produce a good.
Producer Surplus: Seller's payment for a good minus the seller's cost.
Efficiency: The property of market maximizing the total surplus.
Equity: Fairness of the contribution.
Market power: Ability to influence prices.
Externalities: Cause welfare in a market.
Market Failure: The inability of unregulated markets to allocate resources.

Introduction: Welfare Economics
What is welfare economics? Welfare economics is the study of how the allocation of resources affects economic well being.
We will learn about the benefits that buyers and sellers gain from the market and how to maximize their profits.

Consumer Surplus

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Willingness to Pay
Willingness to pay is the maximum amount the a buyer will pay for a good. It also measures how much that buyer values the good. The buyer will buy the good when the price is below his willingness to pay. For example, if the price of Starcraft 2 is $100 and my willingness to pay is $200, then I will immediately buy the CD because that is how much I value Starcraft. In this situation, we say that I received consumer surplus of $100. Consumer surplus is the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it. This measures the benefit to buyers of participating in a market.

Using the Demand Curve to Measure Consumer Surplus
In previous lesson, we learned that consumer surplus and demand are in a close relationship. Therefore, we can use the demand curve, which is willingness to pay, to measure the consumer surplus. On the graph, the demand curve and the price measures the consumer surplus in a market.

How a Lower Price Raises Consumer Surplus
A lower price makes buyers of a good better off because the buyers always want to play less for the goods. The main two reasons that the increase in consumer surplus occurs is because of existing consumers pay less and new consumers enter the market at the lower price.

What Does Consumer Surplus Measure?
We learned that consumer surplus is the amount that buyers are willing to pay for a good minus the amount they actually pay for it.
Consumer surplus measures the benefit that buyers receive from a good as the buyers perceive themselves.

Producer Surplus

Cost and the Willingness to Sell
Cost is the value of everything a seller must give up to produce a good. It also measures her willingness to sell her services. For example, lets say that you work in the steel company. It cost you only $300 to do the job. Since you are willing to do the job for $300, but your monthly payment is $500, we call this a producer surplus. Producer surplus is the amount a seller is paid minus the cost of production.

Using the Supply Curve to Measure Producer Surplus
Just as the relationship between the consumer surplus and the demand curve, producer surplus is related to the supply curve.
We can use the supply curve to measure the producer surplus. On the graph, the area below price and above supply curve measures the producer surplus.

How a Higher Price Raises Producer Surplus
Sellers always want to receive a higher price for their goods. The increase in producer surplus happens when the existing producers are receiving more and new producers enter the market at the higher price.

Video: Consumer and Producer Surplus

Market Efficiency
  • The Benevolent Social Planner
In order to evaluate market outcomes, we use the benevolent social planner. This planner helps maximize the economic well being. The sum of consumer and producer surplus is called total surplus. This is one way to measure the economic well being of a society.
  • Consumer surplus= Value to buyers- Amount paid by buyers
  • Producer surplus= Amount received by sellers= Cost to sellers
  • Total surplus= Value to buyers - Amount paid by buyers + Amount received by sellers - Cost to sellers.
  • Total surplus

Value to buyers = Cost to sellers
  • When an allocation of resources maximizes total surplus, we call the allocation exhibited efficiency. Sometimes, the profit from trade are not realized when the allocation is not efficient.
  • Another thing that the social planner need to care about is equity. Equity is the fairness of the distribution of well being among the members of the society. However, it is not easy to divide the profit equally and fairly.

Evaluating the Market Equilibrium
When we evaluate the market equilibrium, keep asking the following questions. Is the equilibrium allocation of resources efficient?
Does it maximize total surplus?
Market Outcomes:
1. Free markets allocate the supply of goods to the buyers who value them most highly.
2. Free markets allocate the demand for goods to the sellers who can produce them at least cost.
3. Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.
When the quantity is less than the equilibrium quantity, the value to buyers exceeds the cost to sellers.
When the quantity is greater than the equilibrium quantity, the cost to sellers exceeds the value to buyers.

Market Efficiency And Market Failure
We have learned about the consumer and producer surplus and how to evaluate the efficiency of free markets.
Sometimes the markets are not perfectly competitive. There are markets where a single buyer or seller can control the market prices.
We call this ability a market power. Market power keeps the price and quantity away from the equilibrium, which means that the markets are inefficient.
In the meanwhile, side effects happen even though it doesn't affect the people in the market. We call this externalities. Externalities cause welfare in a market to depend on more than the value and the cost. To conclude, these two are the basic phenomenon of market failure. Market failure is the inability of some unregulated markets to allocate resources efficiently.
Market Power

In this chapter, we learned about the basic tools of welfare economics. The consumer and producer surplus, and how to use them to evaluate the efficiency of free markets. The invisible hand maximizes the total benefits to buyers and sellers. Even though we assumed that the markets are efficient, they may not work in certain time. Therefore, the markets do not allocate resources efficiently in the presence of market failures such as market power or externalities.