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.