Ch.7+Consumers,+Producers,+and+the+Efficiency+of+Markets

In this chapter, we are going to discuss mainly about the **welfare economics**, or the study of how the allocation of resources affects economic well-being.

In previous chapters, we have discussed how supply and demand drives the market to equilibrium price. But you may have wondered, at the equilibrium price, are people in the market happy? They sure are satisfied because buyers get the amount they want and sellers sell the amount they want. But they're not //happy// unless they're getting more some extra stuff.

Let's start by looking at what demand curve is really about.

Consumer Surplus
Let's start by discussing what willingness to pay is. **Willingness to pay** is the maximum amount a buyer would pay for a product. We all have different willingness to pay.

In the real world, there are a lot of buyers in a market. But let's say there were only 4 buyers. John, Paul, George, and Ringo. Each of their willingness to pay for a product X is shown on the table below.

__Product X__ If the product X is $40, then all 4 of them will buy it, because they value the product higher than $40. Quantity demanded is 4.
 * Buyer || Willingness to Pay ||
 * John || $100 ||
 * Paul || $80 ||
 * George || $70 ||
 * Ringo || $50 ||

At $40, John would feel $60 richer with the product, because he bought something he valued as $100 at $40. **Consumer surplus** for John is $60.

Likewise at $40, Paul's consumer surplus is $40, George $30, and Ringo $10. **Total consumer surplus** in this market of Product X is $60+$40+$30+$10 = $140

When the price of the product X is $51, then Ringo will be out of the market, because the actual cost is higher than his willingness to pay. Therefore, quantity demanded decreases to 3.

At price $71, George and Ringo are both out of the market. Quantity demanded decreases to 2.

At $101, nobody would buy the product. Quantity demanded is 0.

Do you see the pattern...?

Yes, as the price goes up, the quantity demanded does down. It's the Law of Demand!

Demand curve actually consists from dots that shows each buyer's difference willingness to pay all connected.

Then can we identify where the consumer surplus is on the demand curve graph?

Remember, consumer surplus = $(willingness to pay) - $price

On a demand curve...



The shaded area shows the consumer surplus in a market. You can see that the area shows all the willingness to pay minus the actual price P.

Producer Surplus
Now that we know what consumer surplus is, it's going to be much easier to understand producer surplus. Let's start by **cost**. Cost is the value of what a producer needs to give up to produce a product. No similarity so far? Cost is, in other words, **the willingness to sell**.

__Product Y__
 * Seller || Cost ||~  ||
 * Gecko || $200 ||
 * Prada || $100 ||
 * Tarzan || $80 ||
 * Funky || $70 ||

If the product Y is $300, then all 4 of them will sell it because each can make the product cheaper than $300. Gecko will receive extra $100, Prada extra $200, Tarzan extra $220, and Funky extra $230. Total **producer surplus** is $100+$200+$220+$230 = $750. Quantity supplied is 4.

If the selling price is $150, Gecko will not sell the product because he won't make any profit. Prada receives extra $50, Tarzan extra $70, and Funky extra $80. Quantity supplied is 3.

Like this, as the price goes down, the quantity supplied decreases. The Law of Supply!

Supply curve is all the points of all the sellers' willingness to pay at difference prices.

Remember, producer surplus = $(willingness to sell) - $price

Where in the supply curve represents producer surplus?

Here!



You can see that the shaded area shows all the willingness to sell of the all the different sellers minus the actual price.

[|*Consumer & Producer Surplus]

 * __Key Concept__**
 * welfare economics**: study of how the distribution of resources affects economic well-being
 * willingness to pay**: the maximum amount a consumer would pay for a product
 * consumer surplus**: willingness to pay minus the actual price of a product
 * cost**: the seller's opportunity cost (willingness to pay)
 * producer surplus**: the actual price of a product minus the willingness to pay
 * efficiency**: getting the most out of the scarce resources (cf. how big the cake is)
 * equity:** dividing the scarce resources fairly equally (cf. how many slices the cake is being cut)

Questions 1. If Jim and I try to decide how many slices we should have for the pizza, what are we considering? 2. What is another term for willingness to pay?

Answers 1. equity 2. cost