Chapter 7: Markets and Welfare
Suppose that the price of a new bicycle is $300. Sue values a new bicycle at $400. It costs $200 for the seller to produce the new bicycle. What is the value of total surplus if Sue buys a new bike?
$200
The major advantage of allowing free markets to allocate resources is that the outcome of the allocation is efficient.
T
If buyers are rational and there is no market failure,
free market solutions are efficient and free market solutions maximize total surplus.
An increase in the price of a good along a stationary supply curve
increases producer surplus.
A buyer's willingness to pay is
that buyer's maximum amount he is willing to pay for a good.
consumer surplus
the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it
producer surplus
the amount a seller is paid for a good minus the seller's cost of providing it
If a benevolent social planner chooses to produce more than the equilibrium quantity of a good, then
the cost of production on the last unit produced exceeds the value placed on it by buyers
What does an economist mean by "efficiency"?
It is a resource allocation that maximizes the total surplus received by all members of society.
Consumer surplus is a good measure of buyers' benefits if buyers are rational.
T
Cost to the seller includes the opportunity cost of the seller's time.
T
Equilibrium in a competitive market maximizes total surplus.
T
Producer surplus is the area above the supply curve and below the price.
T
Producer surplus is the area
above the supply curve and below the price.
In general, if a benevolent social planner wanted to maximize the total benefits received by buyers and sellers in a market, the planner should
allow the market to seek equilibrium on its own.
An increase in the price of a good along a stationary demand curve
decreases consumer surplus.
Adam Smith's "invisible hand" concept suggests that a competitive market outcome
maximizes total surplus.
Medical care clearly enhances people's lives. Therefore, we should consume medical care until
the benefit buyers place on medical care is equal to the cost of producing it.
If a market is efficient, then
the market allocates output to the buyers who value it the most. the market allocates buyers to the sellers who can produce the good at least cost. the quantity produced in the market maximizes the sum of consumer and producer surplus.
welfare economics
the study of how the allocation of resources affects economic well-being
cost
the value of everything a seller must give up to produce a good
Suppose the price to repaint her apartments falls to $2,000 each. How many apartments will Lori choose to have repainted? What is the value of her consumer surplus?
Four apartments painted. ($5,000 − $2,000) + ($4,000 − $2,000) + ($3,000 − $2,000) + ($2,000 − $2,000) = $6,000 of consumer surplus.
Suppose the price to paint apartments rises to $4,000 each. How many apartments will Peter choose to repaint? What is the value of his producer surplus?
Four apartments. ($4,000 − $1,000) + ($4,000 − $2,000) + ($4,000 − $3,000) + ($4,000 − $4,000) = $6,000 of producer surplus
The following information describes the value Lori Landlord places on having her five apartment houses repainted. She values the repainting of each apartment house at a different amount depending on how badly it needs repainting. Value of new paint on first apartment house - $5000 Value of new paint on 2nd apartment house - $4000 Value of new paint on 3rd apartment house - $3000 Value of new paint on 4th apartment house - $2000 Value of new paint on 5th apartment house - $1000 Plot Lori Landlord's willingness to pay in Exhibit 1. b. If the price to repaint her apartments is $5,000 each, how many will she repaint? What is the value of her consumer surplus?
One apartment painted. $5,000 − $5,000 = $0, therefore she has no consumer surplus.
If a benevolent social planner sets the price for painting apartment houses at $5,000, what is the value of consumer surplus? producer surplus? total surplus?
Only one unit will be purchased, so consumer surplus = ($5,000 − $5,000) = $0, producer surplus = ($5,000 − $1,000) = $4,000, and total surplus = $0 + $4,000 = $4,000
How does a competitive market choose which producers will produce and sell a product?
Only those producers who have costs at or below the market price will be able to produce and sell that good.
What is producer surplus, and how is it measured?
Producer surplus is the amount a seller is paid for a good minus the seller's cost of providing it. It is measured as the area below the price and above the supply curve.
Short Answer Questions What is the relationship between the buyers' willingness to pay for a good and the demand curve for that good?
The height of the demand curve at any quan- tity is the marginal buyer's willingness to pay. Therefore, a plot of buyers' willingness to pay for each quantity is a plot of the demand curve.
What is consumer surplus, and how is it measured?
The height of the demand curve at any quantity is the marginal buyer's willingness to pay. Therefore, a plot of buyers' willingness to pay for each quantity is a plot of the demand curve.
If a benevolent social planner chooses to produce less than the equilibrium quantity of a good, then
the value placed on the last unit of production by buyers exceeds the cost of production.
Joe has ten baseball gloves, and Sue has none. A baseball glove costs $50 to produce. If Joe values an additional baseball glove at $100 and Sue values a baseball glove at $40, then to maximize
efficiency, Joe should receive the glove.
willingness to pay
the maximum amount that a buyer will pay for a good
The seller's cost of production is
the minimum amount the seller is willing to accept for a good.
If your willingness to pay for a hamburger is $3.00 and the price is $2.00, your consumer surplus is $5.00.
F; $3.00 − $2.00 = $1.00.
If a benevolent social planner sets the price for painting apartment houses at $1,000, what is the value of consumer surplus? producer surplus? total surplus?
Only one unit will be produced, so consumer surplus = ($5,000 − $1,000) = $4,000, producer surplus = ($1,000 − $1,000) = $0, and total surplus = $4,000 + $0 = $4,000.
When the price of a good rises, what happens to producer surplus? Why?
Producer surplus increases because existing sellers receive a greater surplus on the units they were already going to sell and new sellers enter the market because the price is now above their cost.
In Exhibit 3, plot the linear supply and demand curves for painting apartments implied by the information in questions 1 and 2 above (draw them so that they contact the vertical axis). Show consumer and producer surplus for the free market equilibrium price and quantity. Is this allocation of resources efficient? Why or why not?
See Exhibit 8. Yes, it is efficient because at a quantity that is less than the equilibrium quan- tity, we fail to produce units that buyers value more than their cost. At a quantity above the equilibrium quantity, we produce units that cost more than the buyers value them. At equilibrium, we produce all possible units that are valued in excess of what they cost, which maximizes total surplus.
What is the relationship between the sellers' cost to produce a good and the supply curve for that good?
The height of the supply curve at any quantity is the marginal seller's cost. Therefore, a plot of the sellers' cost for each quantity is a plot of the supply curve.
Is a competitive market efficient? Why or why not?
Yes, because it maximizes the area below the demand curve and above the supply curve, or total surplus
Critical Thinking Is it true that you cannot have too much of a good thing? Conversely, is it possible to overproduce unambiguously good things such as food, clothing, and shelter? Why or why not?
You can have too much of a good thing. Yes, any good with a positive cost and a declining willingness to pay from the consumer can be overproduced. This is because at some point of production, the cost per unit will exceed the val- ue to the buyer and there will be a loss to total surplus associated with additional production.
What is the value of consumer surplus for the marginal buyer? Why?
Zero, because the marginal buyer is the buyer who would leave the market if the price were any higher. Therefore, they are paying their will-ingness to pay and are receiving no surplus.
If a market generates a side effect or externality, then free market solutions
are inefficient.
Multiple Choice Questions Consumer surplus is the area
below the demand curve and above the price.
If a buyer's willingness to pay for a new Honda is $20,000 and she is able to actually buy it for $18,000, her consumer surplus is
$2000
If the cost for Moe to mow a lawn is $5, for Larry to mow a lawn is $7, and for Curly to mow a lawn is $9, what is the value of their producer surplus if each mows a lawn and the price for lawn mowing is $10?
($10 − $5) + ($10 − $7) + ($10 − $9) = $9
If the price for painting apartment houses is allowed to move to its free market equilibrium price of $3,000, what is the value of consumer surplus, producer surplus, and total surplus in the market? How does total surplus in the free market compare to the total surplus generated by the social planner?
Consumer surplus = ($5,000 − $3,000) + ($4,000 − $3,000) + ($3,000 − $3,000) = $3,000. Producer surplus = ($3,000 − $1,000) + ($3,000 − $2,000) + ($3,000 − $3,000) = $3,000. Total surplus = $3,000 + $3,000 = $6,000. Free market total surplus is greater than social planner total surplus.
True/False Consumer surplus is the amount a buyer is willing to pay for a good minus the seller's cost.
F; consumer surplus is the amount a buyer is willing to pay for a good minus the amount the buyer actually pays.
Free markets are efficient because they allocate output to buyers who have a willingness to pay that is below the price
F; free markets allocate output to buyers who have a willingness to pay that is above the price.
Producer surplus is a measure of the unsold inventories of suppliers in a market.
F; it is a measure of the benefits of market par- ticipation to the sellers in a market.
Producing more of a product always adds to total surplus.
F; producing above the equilibrium quantity re- duces total surplus because units are produced for which cost exceeds the value to buyers.
Total surplus is the cost to sellers minus the value to buyers.
F; total surplus is the value to buyers minus the cost to sellers
Externalities are side effects, such as pollution, that are not taken into account by the buyers and sellers in a market.
T
If the demand curve in a market is stationary, consumer surplus decreases when the price in that market increases
T
The height of the supply curve is the marginal seller's cost
T
The two main types of market failure are market power and externalities.
T
Suppose there are three identical vases available to be purchased. Buyer 1 is willing to pay $30 for one, buyer 2 is willing to pay $25 for one, and buyer 3 is willing to pay $20 for one. If the price is $25, how many vases will be sold and what is the value of consumer surplus in this market?
Three vases will be sold, and consumer surplus is $0.
Measuring economic well being is with total surplus.
Total Surplus (Value to Buyers - Amt paid by buyers) + (Amt rec'd by sellers - Cost to Sellers) Amt paid by buyers & amt rec'd by sellers cancel Leaves out Total Surplus = Value to Buyers - Cost to Sellers.
The following information shows the costs incurred by Peter Painter when he paints apartments. Because painting is backbreaking work, the more he paints, the higher the costs he incurs in both pain and chiropractic bills. Cost of painting 1st apartment house - $1000 Cost of painting 2nd apartment house - $2000 Cost of painting 3rd apartment house - $3000 Cost of painting 4th apartment house - $4000 Cost of painting 5th apartment house - $5000 Plot Peter Painter's cost in Exhibit 2. b. If the price of painting apartment houses is $2,000 each, how many will he paint? What is the value of his producer surplus?
Two. ($2,000 − $1,000) + ($2,000 − $2,000) = $1,000 of producer surplus.
If a producer has market power (can influence the price of the product in the market) then free market solutions
are inefficient.
Total surplus is the area
below the demand curve and above the supply curve.
efficiency
the property of a resource allocation of maximizing the total surplus received by all members of society
equality
the property of distributing economic prosperity uniformly among the members of society
Can a benevolent social planner choose a quantity that provides greater economic welfare than the equilibrium quantity generated in a competitive market? Why?
Generally, no. At any quantity below the equilib- rium quantity, the market fails to produce units where the value to the marginal buyer exceeds the cost. At any quantity above the equilibrium quantity, the market produces units where the cost to the marginal producer exceeds the value to the buyers.
What happened to Mr. Painter's producer surplus when the price to paint apartments rose? Why?
He received greater producer surplus on the unit he would have produced anyway plus additional surplus on the units he now chooses to produce due to the increase in price.
What happened to Ms. Landlord's consumer surplus when the price of having her apartments repainted fell? Why?
Her consumer surplus rose because she gains surplus on the unit she would have already purchased at the old price plus she gains surplus on the new units she now purchases due to the lower price.
Suppose Lori Landlord has difficulty renting her dilapidated apartments so she increases her willingness to pay for painting by $2,000 per apartment. Plot Lori's new willingness to pay along with Peter's cost in Exhibit 4. If the equilibrium price rises to $4,000, what is the value of consumer surplus, producer surplus, and total surplus? Show consumer and producer surplus on the graph. Compare your answer to the answer you found in 3c above.
See Exhibit 9. Consumer surplus = $3,000 + $2,000 + $1,000 + $0 = $6,000. Producer surplus = $3,000 + $2,000 + $1,000 + $0 = $6,000. Total surplus = $6,000 + $6,000 = $12,000. Consumer surplus, producer surplus, and total surplus have all increased.
