Welfare economics slide 1

Analysis of Competitive MarketsAnalysis of Competitive MarketsIn this section, we examine the social welfare

implications of competitive markets.

The approach taken here (and not the only one possible), is to use the devices of Producer and Consumer Surplus.

The social welfare from the production and consumption of a particular amount of a good is assumed to be the sum of the producer and consumer surplus.

Welfare economics slide 2

Optimality of competitive Optimality of competitive marketsmarkets

The principal claim is that social welfare (the sum of producer and consumer surplus) is maximized at the competitive price and quantity for a good.

A series of examples are worked to show that a variety of policies and regulations, such as price fixing, taxes, and subsidies, will, in general, reduce social welfare from its maximum.

Welfare economics slide 3

Key termsWillingness to pay: The maximum amount a buyer

will pay for an amount of a good.

Consumer surplus: A buyer's willingness to pay minus the amount actually paid.

Cost: The value of everything a seller must give up to produce an amount of a good.

Producer surplus: The amount the seller receives for the good minus the cost.

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Consumer surplus can be measured using the demand curve for a product.

Demand for tacos

D

Q* Q

P

P*

Welfare economics slide 5

When Q* is sold, willingness to pay is the shaded area.

Demand for tacos

D

Q* Q

P

P*

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When Q* is sold at a price P*, consumers pay P* times Q*.

Demand for tacos

D

Q* Q

P

P*

Cost to consumers

Consumer surplus

1) Click to see the cost to consumers. 2) Click again to see the shaded area that is consumer surplus.

Welfare economics slide 7

Producer surplus can be measured using the supply curve for a product.

Supply of tacos S

Q' Q

P

P'

Welfare economics slide 8

The shaded area is the cost of producing Q' of tacos. If the firm can sell at P', the total receipts are P' times Q'.

Supply of tacos

Q' Q

P

P'

1) Click to see the total revenue.

2) Click again to see the costs.

Total

revenue

Costs

Welfare economics slide 9

So producer surplus is the shaded area.

Supply of tacos

S

Q' Q

P

P'

Welfare economics slide 10

S

D

Q

P

QE

PE

When QE is sold at a price of PE, consumer surplus is A, and producer

surplus is B.

A

B

Welfare economics slide 11

Notice on the previous slide that at the market equilibrium the sum of producer and consumer surplus (welfare) is maximized.

Welfare economics slide 12

S

D

Q

P

Q*

P*

Suppose Q' is sold at a price P' . What's the effect on welfare compared

to the market?

Q'

P"

Welfare economics slide 13

S

D

Q

P

QE

PE

Consumer surplus is A . Producer surplus is B plus C. Compared to the market, there is a loss of D plus E. (Note that producers gain

B, while consumers lose B.)

Q'

P'A

B

E

D

C

The next (hidden) slide shows the effects on welfare of producing less than the market

amount.

Click for hidden slide

Welfare economics slide 16

What if MORE than the market equilibrium quantity is produced?

S

D

Q

P

QE

PE

Q'

P'

Welfare economics slide 17

What if MORE than the market equilibrium quantity is produced?

S

D

Q

P

Q'

P'

FE

CB

A

Welfare economics slide 18

When Q' is sold at P':

CS is A + E

PS is (B + C) - (C + E + F) = B - E - F

Therefore:

CS +PS is A + B - F

This is less than CS + PS in the market (= A + B).

Welfare economics slide 20

Conclusion

If the demand curve (willingness to pay) is a good measure of the value of a good, and

if the supply curve (the firm's cost) is a good measure of the cost to society to produce a good,

then the best amount of the good to produce is where supply and demand are equal.