Chapter 5: Efficiency

What will you learn in this chapter? • Use willingness to pay and sell to determine supply and demand at a given price. • Define and calculate surpluses. • Define and identify efficiency. • Describe the distribution of benefits that results from a policy decision. • Define and calculate deadweight loss. • Explain why correcting a missing market can make everyone better off.

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1© 2014 by McGraw‐Hill Education 1 Chapter 5 Efficiency © 2014 by McGraw‐Hill Education 2 What will you learn in this chapter? • Use willingness to pay and sell to determine  supply and demand at a given price. • Define and calculate surpluses. • Define and identify efficiency. • Describe the distribution of benefits that  results from a policy decision. • Define and calculate deadweight loss. • Explain why correcting a missing market can  make everyone better off. © 2014 by McGraw‐Hill Education 3 Willingness to pay and sell  • Consumers many times are willing to pay more than the market price. – A consumer is willing to purchase a good if the  price is below their maximum willingness to pay.  • Producers likewise are willing to sell for less  than the market price. – A producer is willing to sell a good if the price is  above their minimum willingness to sell.  • Voluntary exchanges create value and can  make everyone involved better off. 2© 2014 by McGraw‐Hill Education 4 Willingness to pay and the demand curve 0 100 200 300 400 500 600 1 2 3 4 5 Price ($) Potential buyers Each step represents a camera bought by the additional buyer who becomes interested at that price. Bird watcher Amateur photographer Real estate agent Journalist Teacher Demand Quantity of cameras (millions) 0 100 200 300 400 500 600 10 20 30 40 6050 Price ($) Maximum willingness to pay shapes the demand curve. Five potential buyers’ willingness  to pay forms demand curve. Many buyers’ willingness to pay  forms demand curve. © 2014 by McGraw‐Hill Education 5 Willingness to sell and the supply curve 0 100 200 300 400 500 600 1 2 3 4 5 Potential sellers Price ($) Each step represents the additional camera sold by a seller who becomes interested as the price increases. Art teacher Nature photographer Sales rep (small company) Sales rep (big company) Collector Price ($) 0 100 200 300 400 500 600 10 20 30 40 50 60 70 Supply Quantity of cameras (millions) Minimum willingness to sell shapes the supply curve. Five potential sellers’ willingness  to sell forms demand curve. Many sellers’ willingness to sell  forms supply curve. © 2014 by McGraw‐Hill Education 6 Measuring surplus • When a consumer buys a good below the market  price, this creates value. – Known as consumer surplus, a measure of consumers’  benefit from the purchase. • When a producer sells a good above the market  price, this creates value. – Known as producer surplus, a measure of producers’  benefit from the sale. • Surplus is measured as the difference between  the price at which at which a buyer or seller  would be willing to trade and the actual price. 3© 2014 by McGraw‐Hill Education 7 0 100 200 300 400 500 600 1 2 3 4 5 Potential buyers 1. Total consumer surplus at a price of $160 Price ($) 2. Additional surplus for buyers who would have bought at $160 3. Consumer surplus for the new buyers 1 2 3 0 100 200 300 400 500 600 1 2 3 4 5 Potential buyers 1. Bird watcher’s surplus 2. Amateur photographer’s surplus 3. Real estate agent’s surplus Price ($) 160 1 2 3 Consumer surplus The consumer surplus can be calculated by summing up  individuals’ consumer surplus. At a price of $160, the consumer surplus equals ($500‐$160) + ($250‐$160) + ($200‐$160) = $470. At a price of $100, the consumer surplus equals $470 + $60*3 + $50*1 = $700. © 2014 by McGraw‐Hill Education 8 Active Learning: Calculating consumer surplus Use the following demand schedule to calculate consumer  surplus if the market price is $5. Price Quantity Consumer Surplus 1 280 2 260 3 240 4 220 5 200 6 180 7 160 8 140 © 2014 by McGraw‐Hill Education 9 Producer surplus 0 100 200 300 400 500 600 1 2 3 4 5 1. Collector’s surplus Potential sellers Price ($) 2. Big-company rep’s surplus1 2 2. Surplus lost by collector and big- company rep 160 50 1. Collector’s surplus Potential sellers 0 100 200 300 400 500 600 1 2 3 4 5 Price ($) 1 2 At a price of $160, the producer surplus equals ($160‐$50) + ($160‐$5) = $170 At a price of $100, the producer surplus equals $110. The producer surplus can be calculated by summing up  individuals’ producer surplus. 4© 2014 by McGraw‐Hill Education 10 Active Learning: Calculating producer surplus Use the following supply schedule to calculate producer surplus if  the market price is $5. Price Quantity Producer Surplus 1 130 2 260 3 390 4 520 5 650 6 780 7 910 8 1040 © 2014 by McGraw‐Hill Education 11 Total surplus 0 100 200 300 400 500 600 5 10 15 20 25 30 35 40 45 50 55 60 65 Price ($) D S Quantity of cameras (millions) Producer surplus Consumer surplus $ 4.5 billion $ 3 billion • Total consumer surplus is  equal to the area underneath  the demand curve and above  the equilibrium price. – CS=½*30M*($500‐$200) =$4.5B • Total producer surplus is  equal to the area above the  supply curve and below the  equilibrium price. – PS=½*30M * ($200‐$0) = $3B • Total surplus = CS + PS. Total surplus is the combined benefits that everyone  receives from participating in an exchange of goods or  services. © 2014 by McGraw‐Hill Education 12 Market equilibrium and efficiency 0 100 200 300 400 500 600 5 10 15 20 25 30 35 40 45 50 55 60 65 Price ($) D S Quantity of cameras (millions) Producer surplus Consumer surplus 1 2 4 5 3 Prices abovemarket equilibrium reduce total surplus. • Suppose the price increases  from the equilibrium price of  $200 to $300. • Reduction in cameras sold by  10 million. – Reduces consumer surplus. – Reduces producer surplus. • Buyers pay a higher price,  decreasing consumer surplus  from areas 1, 2, & 4 to area 1. • Sellers sell at a higher price,  increasing producer surplus  from areas 3 & 5 to 2 & 3. The market equilibrium is the point that maximizes total  well‐being (total surplus) of all participants in the market. 5© 2014 by McGraw‐Hill Education 13 Active Learning: Calculating total surplus Use the following graph to calculate the difference in total surplus  if the price increases from $200 to $300. 0 100 200 300 400 500 600 5 10 15 20 25 30 35 40 45 50 55 60 65 Price ($) D S Quantity of cameras (millions) 1 2 4 5 3 © 2014 by McGraw‐Hill Education 14 Market equilibrium and efficiency 0 100 200 300 400 500 600 5 10 15 20 25 30 35 40 45 50 55 60 65 Price ($) D S Quantity of cameras (millions) Producer surplus Consumer surplus Deadweight loss 1 3 4 5 2 Prices below market equilibrium reduce total surplus. Lowering the price from the market equilibrium price  decreases total surplus. • Suppose the price decreases from the  equilibrium price of $200 to $100. • Reduction in cameras sold by 15  million. – Reduces consumer and producer  surplus. – Dead weight loss is areas 4 & 5. • Buyers pay a lower price, changing  consumer surplus from areas 1 & 4 to  areas 1 & 2. • Sellers sell at a lower price, decreasing  producer surplus from areas 2, 3 & 5 to  area 3. • A market is efficientwhen it is at  equilibrium. © 2014 by McGraw‐Hill Education 15 Changing the distribution of total surplus 0 100 200 300 400 500 600 5 10 15 20 25 30 35 40 45 50 Price ($) D S Quantity of cameras (millions) 1 2 5 3 0 100 200 300 400 500 600 5 10 15 20 25 30 35 40 45 50 Price ($) D S Quantity of cameras (millions) 1 3 4 5 2 4 When an artificial price is imposed on a market, surplus is  transferred between consumers and producers. When the price is raised above $200, consumer  surplus area 2 is transferred to producers. When the price is lowered below $200, producer surplus area 2 is transferred to consumers. 6© 2014 by McGraw‐Hill Education 16 Deadweight loss 0 100 200 300 400 500 600 5 10 15 20 25 30 35 40 45 50 55 60 65 Price ($) D S Quantity of cameras (millions) Transactions that no longer take place at the new price Deadweight loss When an artificial price is imposed on a market, a  deadweight loss occurs. The deadweight loss is the loss of  total surplus that results when  the quantity of a good that is  bought and sold is below the  market equilibrium quantity. • Reduction in cameras sold by  10 million. • Reduces consumer and  producer surplus. • Deadweight loss is the gray  triangle. © 2014 by McGraw‐Hill Education 17 Missing markets • A market is missing when there are people  who would like to make exchanges but cannot,  for one reason or another, and opportunities  for mutual benefit do not occur. • This occurs due to: – Public policy. – Lack of accurate information or communication. – Lack of technology to facilitate exchange. © 2014 by McGraw‐Hill Education 18 Summary • The concept of willingness to pay and  willingness to sell are analyzed. – Relationship to demand and supply. • Consumer and producer surplus are  introduced. • Total surplus is maximized at the market  equilibrium price and quantity.
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