Consumers Producers and Market Efficiency Lecture 5 academic

Consumers, Producers and Market Efficiency Lecture 5 – academic year 2014/15 Introduction to Economics Fabio Landini

Where are we… • Lecture 1 : Demand supply model • Lecture 2: Elasticity and its application • Lecture 4: Demand, Supply and economic policy 2

What do we do today? • Allocative efficiency: – how do we measure the welfare of both consumers and producers? • Consumer surplus • Producer surplus • THE INVISIBLE HAND THEOREM 3

QUICK QUIZ If the equilibrium price on the market for cigarettes is equal to 10 Euro a pack, and Government introduces a MAXIMUM price equal to 12 Euro, we obtain… A) … Excess supply: the quantity supplied is greater than the quantity demanded. B). . . Scarcity: the quantity demanded is greater than the quantity supplied. C). . . No effect on the market. 4

Premise: What’s an auction? 5

Two issues 1. Is there a RIGHT price? • Consumers: prices are ALWAYS too high; • Producers: prices are ALWAYS too low. How do we understand which is the ‘right’ price? 6

Two issues 2. Is the MARKET EQUILIBRIUM (that is: p & q) right? • So far: positive analysis of the market; • Now: normative analysis; • We ask: Is the resource allocation produced by the market desirable? In which sense? • How do we measure welfare? 7

Welfare measure The consumer surplus measures the benefit that the consumer obtains from participating to the market. The producer surplus measures the same benefit for the producer. 8

Consumer surplus Willingness to pay: it is the maximum amount that the consumer is willing to pay to obtain the good. It measures the value that the consumer attaches to the good or service. 9

Consumer surplus The demand curve describes the quantity that consumers are willing to buy at different prices. The consumer surplus is the difference between the consumer’s willingness to pay and the price that is effectively paid. 10

Example: willingness to pay for a rare Elvis’s record? Consumer Willingness to pay John 100 Paul 80 George 70 Ringo 50 11

Summary: demand table Price Consumers Quantity Demanded >100 None 0 80 -100 John 1 70 - 80 John, Paul 2 50 - 70 John, Paul, George 3 < 50 John, Paul, George, Ringo 4 12

Consumer surplus and demand curve – Price=80 Price 100 Consumer surplus John (20 euro) 80 70 50 0 1 2 3 4 Quantity 13

Consumer surplus and demand curve – Price=70 Price 100 Consumer surplus John (30 euro) 80 70 50 0 Consumer surplus Paul (10 euro) Total consumer surplus (40 euro) 1 2 3 4 Quantity 14

Consumer surplus and demand curve – Price=70 Price 100 Consumer surplus John (30 euro) 80 70 50 Consumer surplus Paul (10 euro) Total consumer surplus (40 euro) Domanda 0 1 2 3 4 Quantity 15

Consumer surplus and price Consumer surplus = area in between the demand curve and the price level. There exist a negative relationship between price and consumer surplus. 16

Effects of price variations on consumer surplus Price P 1 B A Surplus of initial consumer C Demand 0 Q 1 Quantity 17

Effects of price variations on consumer surplus Price P 1 B P 2 A Surplus of initial consumer C F D Demand 0 Q 1 Q 2 Quantity 18

Effects of price variations on consumer surplus Price P 1 B P 2 A Surplus of initial consumer C E D Additional surplus for the initial consumer 0 Surplus for the new consumer Q 1 F Demand Q 2 Quantity 19

Producer surplus Supply curve • It describes the quantity that the producers are willing to sell for each price; • The willingness to sell is determined by the costs of production (measured as an opportunity cost); • As the market price increases, less efficient producers can enter the market 20

Producer surplus The producer surplus is the difference between the price paid by the consumer and the cost of production. It measures the benefit that the producer obtains from participating to the market. 21

Example: willingness to sell a rare Elvis’s record? Producer Costs Mick 900 Keith 800 Charli 600 Bill 500 22

Summary: Table of supply Price Sellers Quantity supplied P > 900 Bill, Charlie, Keith e Mick 4 800 -900 Bill, Charlie, Keith 3 600 -800 Bill, Charlie 2 500 - 600 Bill 1 None 0 P < 500 23

To measure the producer surplus with the supply curve Price 900 800 600 500 Bill’s surplus (100 euro) if p=600 0 1 2 3 Quantity 24

To measure the producer surplus with the supply curve Price Total producer surplus (500 euro) 900 800 Charlie’s surplus (200 euro) if p=800 600 500 Bill’s surplus (300 euro) if p=800 0 1 2 3 Quantity 25

To measure the producer surplus with the supply curve Price Total producer surplus (500 euro) Supply 900 800 Charlie’s surplus (200 euro) if p=800 600 500 Bill’s surplus (300 euro) if p=800 0 1 2 3 Quantity 26

Effects of price variations on producer surplus Price Supply P 1 B Surplus of initial producer C A 0 Q 1 Q 2 Quantity 27

Effects of price variations on producer surplus Price Supply P 2 P 1 B Surplus of initial producer C A 0 Q 1 Q 2 Quantity 28

Effects of price variations on producer surplus Price Supply Additional surplus for initial producer P 2 P 1 D B Surplus of initial producer F C Surplus for the new producer A 0 Q 1 Q 2 Quantity 29

Market efficiency In a market with perfect competition and no externalities: • Social welfare = consumer surplus + producer surplus 30

Consumer surplus and producer surplus in equilibrium Price A D Equilibrium price Supply E B Demand C 0 Equilibrium quantity Quantity 31

Consumer surplus and producer surplus in equilibrium Price A D Equilibrium price Supply E Producer surplus B Demand C 0 Equilibrium quantity Quantity 32

Consumer surplus and producer surplus in equilibrium Price A D Supply Consumer surplus Equilibrium price E Producer surplus B Demand C 0 Equilibrium quantity Quantity 33

Allocative efficiency obtains when the allocation of resources maximizes total surplus. Does a perfectly competitive market achieve allocative efficiency? 34

Market equilibrium and allocative efficiency In a free market: • The supply of a good goes to those consumers that evaluate the good the most. • The demand of a good is satisfied by the sellers that con produce the good at the lowest cost. • The quantity of good that maximizes the sum of consumer surplus and producer surplus is finally produced. 35

Graphical demonstration Price Supply Value for the consum er Cost for the producer 0 Equilibrium quantity The value for the consumer is greater than the cost for the producer. Value for the consum er The value for the consumer is lower than the cost for the producer. Demand Quantity 36

The invisible hand In a free market there exist several producers and consumers, each motivated by her own selfinterest. Thanks to the price system (= impersonal coordination and communication device): • Individual decisions of producers and consumers leads to an efficient allocation of resources. This is the INVISIBLE HAND THEOREM. 37

Does the invisible hand theorem always hold? No, in two cases at least: 1. Market power; 2. Externalities. In these cases we usually talk about MARKET FAILURES. 38

Market power • Market power= when consumers or producers have some control over market prices – we talk about “imperfect competition” (monopoly, oligopoly). • Market power generates inefficiencies (=“market failures”), because market prices do not reflect social cost of resources. 39

Externalities: when the decisions of consumers and producers have “external effects”, i. e. effects (both costs and benefits) on individuals that do not participate to the market. Externalities generate inefficiencies (= “market failures”), because market prices do not reflect the social cost of resources. 40

Welfare Consumer surplus and producer surplus measure the benefits that consumers and producers can derive from participating to the market 41

Efficiency An allocation of resources that maximizes the total surplus (= consumer surplus + producer surplus) is called “efficient” The existence of market power and externalities can lead to inefficient results and market failures 42

Conclusions Keep in mind: social welfare is not only efficiency, but also equity! We will talk about that later in the course…. 43

Next week Economic policy and efficiency: exercises and applications 44