Analysis of Competitive Markets

1. Analysis of Competitive Markets • In this section, we examine the social welfare implications of competitive markets. • The approach taken here (and not the only one possible), is to use the devices of Producer and Consumer Surplus. • The social welfare from the production and consumption of a particular amount of a good is assumed to be the sum of the producer and consumer surplus. Welfare economics

2. Optimality of competitive markets • The principal claim is that social welfare (the sum of producer and consumer surplus) is maximized at the competitive price and quantity for a good. • A series of examples are worked to show that a variety of policies and regulations, such as price fixing, taxes, and subsidies, will, in general, reduce social welfare from its maximum. Welfare economics

3. Key terms • Willingness to pay: The maximum amount a buyer will pay for an amount of a good. • Consumer surplus: A buyer's willingness to pay minus the amount actually paid. • Cost: The value of everything a seller must give up to produce an amount of a good. • Producer surplus: The amount the seller receives for the good minus the cost. Welfare economics

4. Consumer surplus can be measured using the demand curve for a product. P Demand for tacos P* D Q* Q Welfare economics

5. When Q* is sold, willingness to pay is the shaded area. P Demand for tacos P* D Q* Q Welfare economics

6. Consumer surplus Cost to consumers 1) Click to see the cost to consumers. 2) Click again to see the shaded area that is consumer surplus. • When Q* is sold at a price P*, consumers pay P* times Q*. P P* Demand for tacos D Q* Q Welfare economics

7. Producer surplus can be measured using the supply curve for a product. S P Supply of tacos P' Q' Q Welfare economics

8. Total revenue Costs Supply of tacos • Click to see the total revenue. • 2) Click again to see the costs. • The shaded area is the cost of producing Q' of tacos. If the firm can sell at P', the total receipts are P' times Q'. P P' Q' Q Welfare economics

9. So producer surplus is the shaded area. S P Supply of tacos P' Q' Q Welfare economics

10. A B When QE is sold at a price of PE, consumer surplus is A, and producer surplus is B. P S PE D Q QE Welfare economics

11. Notice on the previous slide that at the market equilibrium the sum of producer and consumer surplus (welfare) is maximized. Welfare economics

12. Suppose Q' is sold at a price P' . What's the effect on welfare compared to the market? P S P" P* D Q Q' Q* Welfare economics

13. Consumer surplus is A . Producer surplus is B plus C. Compared to the market, there is a loss of D plus E. (Note that producers gain B, while consumers lose B.) P S A P' B D PE E D C Q Q' QE Welfare economics

14. The next (hidden) slide shows the effects on welfare of producing less than the market amount. Click for hidden slide

15. P • What if MORE than the market equilibrium quantity is produced? S PE P' D Q Q' QE Welfare economics

16. P • What if MORE than the market equilibrium quantity is produced? S A F E P' B D C Q Q' Welfare economics

17. When Q' is sold at P': • CS is A + E • PS is (B + C) - (C + E + F) = B - E - F • Therefore: • CS +PS is A + B - F • This is less than CS + PS in the market (= A + B). Welfare economics

18. Conclusion • If the demand curve (willingness to pay) is a good measure of the value of a good, and • if the supply curve (the firm's cost) is a good measure of the cost to society to produce a good, • then the best amount of the good to produce is where supply and demand are equal. Welfare economics