Consumers, Producers and the efficiency of markets

When consumers go to grocery stores to buy their turkeys for Thanksgiving dinner, they may be disappointed that the price of turkey is as high as it is. At the same time, when farmers bring to market the turkeys they have raised, they wish the price of turkey were even higher. These views are not surprising. Buyers always want pay less and sellers always want to get paid more. But is there a right price for turkey from the standpoint of society as a whole?

We saw how, in market economies the forces of supply and demand determine the prices of goods and services and the quantities sold. So far, however we have described the way markets allocate scarce resources without directly addressing the question of whether these market allocations are desirable. In other words, our analysis has been positive (what is) rather than normative (what should be). We know that the price of Turkey adjusts to ensure that the quantity of turkey supplied equals the quantity of turkey demanded. But at this equilibrium is the quantity of turkey produced and consumed too small, too large or just right?

Welfare economics: the study of how the allocation of resources affects economic well being.

We take up the topic of welfare economies, the study of how the allocations of resources affect economic well being. We begin by examining the benefits that buyers and sellers receive from taking part in a market. We then examine how society can make these benefits as large as possible. This analysis leads to a profound conclusion. The equilibrium of supply and demand in the market maximizes the total benefits received by buyers and sellers.

One of ten principles of economics is that markets are usually a good way to organize economic activity. The study of welfare economics explains this principle more fully. It also answers out question about the right price of turkey. The price that balances the supply and demand for turkey is, in particular sense, the best one because it maximizes the total welfare of turkey consumers and turkey producers.

Consumer Surplus

We begin our study of welfare economics by looking at the benefits buyers receive from participating in a market.

Willingness to pay

Imagine that you own a mint-condition recording of Elvis Presley first album. Because you are not an Elvis Presley fan, you decide to sell it. One way to do so is to hold an auction.

Four Elvis fans show up your auction John, Paul, George and Ringo. Ach of them would like to own the album, but there is a limit to the amount that each is willing to pay for it. Table shows the maximum price that each of the four possible buyers would pay. Each buyer’s maximum is called his willingness to pay and it measures how much that buyer values the good. Each buyer would be eager to buy the album at a price les than his willingness to pay and he would refuse to buy the album at a greater price greater than his willingness to pay at a price equal to his willingness to pay the buyer would be indifferent about buying the good: If the price is exactly the same as the value he places on the album he would be equally happy buying it or keeping his money.

To sell your album you begin the bidding at a low price, say $10. Because all four buyers are willing to pay much move the price rises quickly. The bidding stops when John bids $80 (or slightly more). At this point, Paul, George and Ringo have dropped out of the bidding because they are unwilling to bid any more than $80 John pays you $80 and gets the album. Note that the album has gone to buyer who values the album most highly.

Consumer surplus measures the benefit to buyers of participating in a market. In this example, John receives a $20 benefit from participating in the auction because he pays only $80 for a good he values at $100 Paul, George, and Ringo get no consumer surplus from participating in the auction because they left without the album and without paying anything.

In this case, the bidding stops when Paul bid $70 (or slightly higher). At this price, John and Paul are each happy to buy an album, and George and Ringo are not willing to bid any higher. John and Paul each receive consumer surplus equal to his willingness to pay minus the price John’s consumer surplus is $30 and Paul’s is $10. John’s consumer surplus is higher now than it was previously because he gets the same album but pays less for it. The total consumer surplus is the market is $40.