N.

GREGORY MANKIW
PRINCIPLES OF

ECONOMICS
Eighth Edition

CHAPTER Consumers, Producers, and

the Efficiency of Markets
7
Premium PowerPoint Slides by:
V. Andreea CHIRITESCU
Eastern Illinois University
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 Look for the answers to these questions:
• What is consumer surplus? How is it
related to the demand curve?
• What is producer surplus? How is it
related to the supply curve?
• Do markets produce a desirable allocation
of resources? Or could the market
outcome be improved upon?

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 Welfare Economics
• Allocation of resources refers to:
– How much of each good is produced
– Which producers produce it
– Which consumers consume it
• Welfare economics
– Studies how the allocation of resources
affects economic well-being

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 Willingness to Pay (WTP)
• A buyer’s willingness to pay for a good
– Maximum amount the buyer will pay for
that good
– How much the buyer values the good
name WTP
Example:
Anthony $250 4 buyers’ WTP
Chad 175 for an iPod
Flea 300
John 125
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 WTP and the Demand Curve

Q:If price of iPod is $200, who will buy an

iPod, and what is quantity demanded?

name WTP
A: Anthony & Flea will buy an
iPod, Chad & John will not.
Anthony $250
Hence, Qd = 2
Chad 175 when P = $200.
Flea 300
John 125
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 WTP and the Demand Curve
• Derive the
P (price
demand of iPod)
who buys Qd
schedule:
$301 & up nobody 0

251 – 300 Flea 1

name WTP
176 – 250 Anthony, Flea 2
Anthony $250
Chad, Anthony,
Chad 175 126 – 175 3
Flea
Flea 300 John, Chad,
0 – 125 4
John 125 Anthony, Flea
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 WTP and the Demand Curve
P
$350
P Qd
$300
$250 $301 & up 0

$200 251 – 300 1

$150 176 – 250 2
$100
126 – 175 3
$50
0 – 125 4
$0
Q
0 1 2 3 4
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 About the Staircase Shape…
This D curve looks like a
P staircase with 4 steps –
$350 one per buyer.
$300
If there were a huge # of
$250 buyers, as in a
$200 competitive market, there
would be a huge # of
$150 very tiny steps, and it
$100 would look more like a
smooth curve.
$50
$0
Q
0 1 2 3 4
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 WTP and the Demand Curve
P Flea’s WTP At any Q, the height
$350 of the D curve is
$300 Anthony’s WTP
the WTP of the
$250 Chad’s WTP marginal buyer,
$200 John’s the buyer who
$150 WTP would leave the
market if P were
$100
any higher.
$50
$0
Q
0 1 2 3 4
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 Consumer Surplus (CS)
• Consumer surplus CS = WTP – P
– Amount a buyer is willing to pay minus the
amount the buyer actually pays:

name WTP Suppose P = $260.

Anthony $250 Flea’s CS = $300 – 260 = $40.
Chad 175 The others get no CS because they
do not buy an iPod at this price.
Flea 300
Total CS = $40.
John 125
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 CS and the Demand Curve
P P = $260
Flea’s WTP
$350 Flea’s CS =
$300 $300 – 260 = $40
$250 Total CS = $40
$200
$150
$100
$50
$0
Q
0 1 2 3 4
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 CS and the Demand Curve
Instead, suppose P = $220
P
Flea’s WTP Flea’s CS = $300 – 220 = $80
$350
$300 Anthony’s WTP
Anthony’s CS = $250 – 220 =
$250 $30
$200 Total CS = $110
$150 Total CS equals the area
under the demand curve
$100
above the price, from 0
$50 to Q.
$0
Q
0 1 2 3 4
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 CS with Lots of Buyers & a Smooth D Curve

Price
per pair P The demand for shoes
$ 60
At Q = 5, the 50
marginal buyer is
40
willing to pay $50 for
pair of shoes. 30
Suppose P = $30. Pairs of shoes
20
Then his consumer
surplus = $20. 10
D
0 Q
0 5 10 15 20 25 30
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 CS with Lots of Buyers & a Smooth D Curve

CS is the area
between P and the P The demand for shoes
D curve, from 0 to Q.
$ 60
Recall: area of 50
a triangle equals h
40
½ x base x height
30
Height = 20
$60 – 30 = $30.
So, 10
CS = ½ x 15 x $30 D
0 Q
= $225.
0 5 10 15 20 25 30
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 How a Higher Price Reduces CS

P If P rises to $40,
60 CS = ½ x 10 x $20
1. Fall in CS
= $100.
due to buyers 50
leaving market Two reasons for
40 the fall in CS.
30

2. Fall in CS due to 20
remaining buyers 10
D
paying higher P 0 Q
0 5 10 15 20 25 30
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 Consumer Surplus
Video:

https://www.youtube.com/watch?v=oL20S7
c0ZJE

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management system for classroom use.
 Producer Surplus
• Cost
– Value of everything a seller must give up to
produce a good
• Measure of willingness to sell: produce and
sell the good/service only if the price > cost

name cost Example: Costs of 3

Jack $10 sellers in the lawn-cutting
business.
Janet 20
Chrissy 35
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 Producer Surplus
• Derive the supply
P Qs
schedule from the
cost data: $0 – 9 0

10 – 19 1

20 – 34 2
name cost
35 & up 3
Jack $10
Janet 20
Chrissy 35
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management system for classroom use.
 Cost and the Supply Curve

P
$40 P Qs

$0 – 9 0
$30
10 – 19 1
$20
20 – 34 2

$10 35 & up 3

$0
Q
0 1 2 3
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 Cost and the Supply Curve

P At each Q, the
$40 height of the S
Chrissy’s curve is the cost
of the marginal
$30 cost seller, the seller
Janet’s who would leave
$20 cost the market if the
price were any
$10 Jack’s cost lower.

$0 Q
0 1 2 3
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 Producer Surplus
• Producer surplus, PS = P - cost
– Amount a seller is paid for a good minus
the seller’s cost of providing it
– Price received minus willingness to sell

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 Producer Surplus and the S Curve
PS = P – cost
P
Suppose P = $25.
$40
Chrissy’s Jack’s PS = $15
$30 cost Janet’s PS = $5
Janet’s Chrissy’s PS = $0
$20 cost
Total PS = $20
$10 Jack’s cost
Total PS equals the area
$0 above the supply curve
Q under the price, from 0 to Q.
0 1 2 3
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 PS with Lots of Sellers & a Smooth S Curve

Price P The supply of shoes

per pair
60
Suppose P = $40. 50 S

At Q = 15, the 40
marginal seller’s cost 30
is $30, Pairs of shoes
and her producer 20
surplus is $10. 10
0 Q
0 5 10 15 20 25 30
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 PS with Lots of Sellers & a Smooth S Curve

PS is the area P The supply of shoes

between P and the S
60
curve, from 0 to Q.
50 S
The height of this
triangle is 40
$40 – 15 = $25.
30
So, h
PS = ½ x b x h 20
= ½ x 25 x $25 10
= $312.50
0 Q
0 5 10 15 20 25 30
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 How a Lower Price Reduces PS

If P falls to $30,
P 1. Fall in PS
PS = ½ x 15 x $15 due to sellers
60
= $112.50 leaving market
50 S
Two reasons for
the fall in PS. 40
30

2. Fall in PS due to 20
remaining sellers 10
getting lower P
0 Q
0 5 10 15 20 25 30
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 Producer Surplus

Video:

https://www.youtube.com/watch?v
=ECz2hEbEagw

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 26
 Market Efficiency
• Total surplus = CS + PS
– Consumer surplus = Value to buyers –
Amount paid by buyers
• Buyers’ gains from participating in the market
– Producer surplus = Amount received by
sellers – Cost to sellers
• Sellers’ gains from participating in the market
Total surplus = Value to buyers – Cost to sellers

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use.
 Market Efficiency
Video:
https://www.youtube.com/watch?v=ze1XRw
b4hD8

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management system for classroom use.
 Market’s Allocation of Resources
• Allocation of resources – desirable?
– Decentralized (in a market economy)
• Determined by interactions of many self-
interested buyers and sellers
– Total surplus – measure of society’s well-
being
• To consider whether the market’s allocation is
efficient

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management system for classroom use.
 Market’s Allocation of Resources
• Efficient allocation of resources
maximizes total surplus
1. The goods are consumed by the buyers
who value them most highly
2. The goods are produced by the
producers with the lowest costs
3. Raising or lowering the quantity of a
good would not increase total surplus

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 Evaluating the Market Equilibrium

Market equilibrium: P
P = $30
60
Q = 15
Total surplus 50 S
= CS + PS
40 CS
Is the market 30
equilibrium efficient? PS
20
10
D
0 Q
0 5 10 15 20 25 30
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 Which Buyers Consume the Good?

Every buyer whose

P
WTP is ≥ $30 will buy.
60
Every buyer whose
50 S
WTP is < $30 will not.
40
30

The buyers who 20

value the good most 10
highly are the ones D
0 Q
who consume it.
0 5 10 15 20 25 30
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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 32
 Which Sellers Produce the Good?

Every seller whose P

cost is ≤ $30 will 60
produce the good.
50 S
Every seller whose 40
cost is > $30 will 30
not.
20
The sellers with 10
the lowest cost D
0 Q
produce the good.
0 5 10 15 20 25 30
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 Market Efficiency
• Adam Smith’s invisible hand
– Takes all the information about buyers and
sellers into account
– Guides everyone in the market to the best
outcome
– Economic efficiency
• Free markets
– Best way to organize economic activity

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 Market Efficiency & Market Failure
• Forces of supply and demand
– Allocate resources efficiently
• Assumptions about how markets work
1. Markets are perfectly competitive
2. Outcome in a market matters only to the
buyers and sellers in that market
• When these assumptions do not hold
– “Market equilibrium is efficient” may no
longer be true
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 Market Efficiency & Market Failure
• Market failures
– Market power: a single buyer or seller
(small group) control market prices
• Markets are inefficient
– Externalities: decisions of buyers and
sellers affect people who are not
participants in the market at all
• Inefficient equilibrium - from the standpoint of
society as a whole

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