Consumer Surplus, Producer Surplus, and Market Efficiency

1. Consumer Surplus, Producer Surplus, and Market Efficiency

2. Welfare Economics • Welfare economics: the study of how the allocation of resources affects economic well-being • Transition from positive analysis to normative analysis

3. Consumer Surplus • Consumer surplus (CS): the area below the demand curve and above the price line • CS = Total WTP – total expenditure • A measure of consumer(s) well-being

4. Producer Surplus • Producer surplus (PS): the area above the supply curve and below the price line • PS = Total revenue (TR) – variable costs (VC) • A measure of producer(s) well-being • Relationship between profit and PS? • Profit = TR – TC = TR – (FC + VC) • Not the same if FC > 0

5. Efficiency • Total surplus: TS = CS + PS • Measure of consumer(s) and producer(s) well-being • Efficiency: the property of a resource allocation of maximizing the TS received by all members of society • Efficiency is the normative criteria of economics

6. Perfectly Competitive Markets are Efficient • The equilibrium price and quantity (P*,Q*) maximize total surplus • Proof by contradiction • If Q < Q*, there is a deadweight loss (DWL) and TS is lower • If Q > Q*, there is a DWL and TS is lower • Must be true that Q* and therefore P* maximize TS • This is Adam Smith’s “Invisible Hand” at work

7. Concepts Relating Efficiency and Equity • Pareto efficiency: a situation where no one can be made better-off without making someone else worse-off • Pareto improvement: a change that makes at least one individual better-off without making anyone else worse-off • Potential Pareto improvement: a change that makes some people better-off by enough that they could compensate any losers so that no one is made worse-off