Chapter 5 - Efficiency. In this chapter you will learn: 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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Chapter 5
Efficiency
What will you learn in this chapter?
supply and demand at a given price.
results from a policy decision.
make everyone better off.
Willingness to pay and sell
than the market price.
– A consumer is willing to purchase a good if the
price is below their maximum willingness to pay.
than the market price.
– A producer is willing to sell a good if the price is
above their minimum willingness to sell.
make everyone involved better off.
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Willingness to pay and the demand curve
0
100
200
300
400
500
600
Price ($)
Potential buyers
Each step represents a camera
bought by the additional buyer who
becomes interested at that price.
Bird watcher
Amateur photographer
Real estate agent
Journalist Teacher
Demand
Quantity of cameras (millions)
0 100 200 300 400 500 600
Price ($)
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.
Willingness to sell and the supply curve
0
100
200
300
400
500
600
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
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.
Measuring surplus
price, this creates value.
– Known as consumer surplus , a measure of consumers’
benefit from the purchase.
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.
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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
3 Consumer surplus for the new buyers 1
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
Active Learning: Calculating consumer surplus
Use the following demand schedule to calculate consumer
surplus if the market price is $5.
Price Quantity Consumer Surplus
Producer surplus
0
100
200
300
400
500
600
1 Collector’s
surplus
Potential sellers
Price ($)
2 Big-company
rep’s surplus
1 2
2 Surplus lost by company rep
160
50 1 Collector’s surplus
Potential sellers
0 100 200 300 400 500 600
Price ($)
1 2
At a price of $160, the producer surplus equals At a price of $100, the producer surplus equals
The producer surplus can be calculated by summing up
individuals’ producer surplus.
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Active Learning: Calculating producer surplus
Use the following supply schedule to calculate producer surplus if
the market price is $5.
Price Quantity Producer Surplus
Total surplus
0
100
200
300
400
500
600
Price ($)
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) = $3B
• Total surplus = CS + PS.
receives from participating in an exchange of goods or
Market equilibrium and efficiency
0
100
200
300
400
500
600
Price ($)
D S
Quantity of cameras (millions)
Producer surplus Consumer surplus
1
2
4
5
3
Prices above market
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.
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Active Learning: Calculating total surplus
Use the following graph to calculate the difference in total surplus
if the price increases from $200 to $300.
0
100
200
300
400
500
600
Price ($)
D S
Quantity of cameras (millions)
1
2
4
5
3
Market equilibrium and efficiency
0
100
200
300
400
500
600
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 $100
• Reduction in cameras sold by 15 million
– Reduces consumer and producer surplus
– Dead weight loss is areas 4 & 5
• Buyers pay a lower price, changing consumer surplus from areas1 & 4 to areas 1 & 2
• Sellers sell at a lower price, decreasing producer surplus from areas 2, 3 & 5 to area 3
• A market is efficientwhen it is at equilibrium
Changing the distribution of total surplus
0
100
200
300
400
500
600
Price ($)
D S
Quantity of cameras (millions)
1
2
5
3
0 100 200 300 400 500 600
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 When the price is lowered below $200, producer
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Deadweight loss
0
100
200
300
400
500
600
Price ($)
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.
Missing markets
who would like to make exchanges but cannot,
for one reason or another, and opportunities
for mutual benefit do not occur.
– Public policy.
– Lack of accurate information or communication.
– Lack of technology to facilitate exchange.
Summary
willingness to sell are analyzed.
– Relationship to demand and supply.
introduced.
equilibrium price and quantity.