Chapter 7: Consumers, Producers, and the Efficiency
of Markets
Welfare economics: The study of how the allocation of resources
affects economic well-being. This is a normative analysis (i.e. what should
be).
7.1 Consumer Surplus
Willingness to pay: The maximum amount that a buyer will pay for a
good.
Consumer surplus: The amount a buyer is willing to pay for a good
minus the amount the buyer actually pays for it.
“The area below the demand curve and above the price measures the
consumer surplus in a market.”
In most markets, consumer surplus is a good proxy for economic well-
being.
7.2 Producer Surplus
Cost: The value of everything a seller must give up to produce a good.
Example: For a house painter this includes the cost for equipment and
materials (paint brushes) and the cost of time.
Producer surplus: The amount a seller is paid for a good minus the
seller’s cost of providing it.
“The area below the price and above the supply curve measures the
producer surplus in a market.”
7.3 Market Efficiency
Consumer surplus and producer surplus are basic metrics used by
economists to study the welfare of buyers and sellers in a market. They
help answer the question: “Is the allocation of resources determined by free
markets desirable?”
Total surplus: The sum of consumer and producer surplus for a given
market.
o Consumer surplus = Value to buyers - Amount paid to buyers
o Producer surplus = Amount received by sellers - Cost to sellers
o 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 society.
Efficiency in examples:
o An allocation is inefficient if a good is not being produced by the
sellers with lowest cost. Solution: raise total surplus by moving
production of the good from high cost sellers to lower cost sellers.
o An allocation is inefficient if a good is not being consumed by the
buyers who value it most highly. Solution: raise total surplus by moving
consumption of the good from a buyer with a low valuation to a buyer
with a high valuation.
Equality: The property of distributing economic prosperity uniformly
among the members of society.
Three insights about market outcomes:
1. “Free markets allocate the supply of goods to the buyers who
value them most highly, as measured by their willingness to pay.”
2. “Free markets allocate the demand for goods to the sellers who
can produce them at the lowest cost.”
3. “Free markets produce the quantity of goods that maximizes the
sum of consumer and producer surplus.”
The equilibrium outcome is an efficient allocation of resources.
Laissez faire: French phrase that is used as shorthand for the policy to
“let the people do as they will” or to “let the market decide.”
7.4 Conclusion: Market Efficiency and Market Failure
Market efficiency depends on several assumptions. If these
assumptions are not true, the market may not function efficiently as it
should under ideal circumstances.
Two key assumptions:
1. Markets are perfectly competitive.
In real economies, competition is sometimes imperfect. In
some markets a single buyer or single seller may have control of
market prices.
Market power: The ability to influence prices.
Market power can be inefficient if it prevents the price and
quantity from reaching the same equilibrium that free market supply
and demand would arrive at.
2. The assumption that only buyers and sellers care about the
market outcome.
Decisions of market participants sometimes affect those
who do not directly participate in the market.
Pollution is a classic example of this phenomenon.
Externalities: the side-effects exhibited or created by a
market.
Buyers and sellers often ignore these side effects when
considering the buyer’s value and the seller’s costs.
“Equilibrium in a market can be inefficient from the
standpoint of society as a whole.”
Market failure: The inability of some unregulated markets to allocate
resources efficiently.
Public policy is one potential remedy for failed markets (to increase
economic efficiency).
