Professional Documents
Culture Documents
Fall 2010
Outline
Weve already talked about the notion of efficiency, noting that the
market usually lead to efficient outcomes (Principle #8).
Weve also noted that that there are gains from trade through
specialization (Principle #5).
Some natural questions we might ask are:
1 Is there a way to measure (i.e., quantify) the gains from trade?
2 Similarly, when there are inefficiencies in the market (either intentional,
as a means of achieving equity, or unintentional, due to market failure
or intervention in the market), can we measure the corresponding loss?
In this chapter, we introduce the notions of consumer surplus and
producer surplus to answer these questions.
Marginal Willingness-to-Pay
Suppose we know that Joseph has the following MWTP for shoes
So, what is the net gain to Joseph if he buys 2 pairs of shoes at $90
per pair?
Well, he would have been willing to pay $120 for the first pair, but
only paid $90, for a net gain (or surplus) of $120 - $90 = $30.
For the second pair, his surplus is smaller, since he is only WTP $100
for the second pair of shoes.
In this case, the surplus is $100 - $90 = $10.
Josephs total consumer surplus is $30 + $10 = $40
Graphically, this total surplus is the area above the market price and
below the individuals demand curve.
Suppose we now have several consumers in the market for shoes, with
MWTPs
Price Joseph Michael John Mary
1 120 110 90 85
2 100 70 65 75
3 80 30 40 65
4 60 0 15 25
Consumer Surplus
In a large market, or in a market where quantities need not be
integers, the demand curve is typically drawn as smooth
Consumer surplus is still the area above the price and below the
demand curve
Quantity Sams MC
1 $20
2 $40
3 $80
4 $100
So, what is the net gain to Sam if he sells 2 pairs of shoes at $70 per
pair?
Well, the first pair of shoes cost him $20 to produce, but he sold
them for $70, for a net gain (or surplus) of $70 - $20 = $50.
For the second pair, his surplus is smaller, since they cost him $40 to
produce.
In this case, the surplus is $70 - $40 = $30.
Sams total producer surplus is $40 + $30 = $70
Graphically, this total surplus is the area above the producers supply
curve and below the price.
Suppose we now have several producers in our shoe market, with MCs
Price Sam Annie Mark Cathy
1 20 40 25 50
2 40 80 50 60
3 80 120 75 70
4 100 160 100 80
Individual MC Graphs
Producer Surplus
In a large market, or in a market where quantities need not be
integers, the supply curve is typically drawn as smooth
Producer surplus is still the area above the supply curve and below
the price
Graphically
Government Intervention
As Krugman and Wells note in their Principle #9: When markets
dont achieve efficiency, government intervention can improve
societys welfare resulting from
1 poorly defined property rights;
2 inaccuracies of price as economic signals.
The authors note three key problem areas:
1 Market power
2 Externalities
3 Goods (e.g., public goods, common property resources, etc.) that by
their nature are unsuited to traditional markets or property right
assignments.
While it is true that government intervention can improve welfare, it
is not necessarily the case that they will improve welfare.
Understanding the unintended consequences of market interventions
is key to setting public policy.