Economic Efficiency Analysis
Welfare economics is the study of how the
allocation of resources affects economic well-
being.
Buyers and sellers receive benefits from taking
part in the market.
The equilibrium in a market maximizes the
total welfare of buyers and sellers.
Equilibrium in the market results in maximum
benefits, and therefore maximum total welfare
for both the consumers and the producers of
the product.
Consumer surplus measures economic welfare
from the buyer’s side.
Producer surplus measures economic welfare
from the seller’s side.
Willingness to pay is the maximum amount
that a buyer will pay for a good.
It measures how much the buyer values the
good or service.
Consumer surplus is the buyer’s willingness to
pay for a good minus the amount the buyer
actually pays for it.
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The market demand curve depicts the various
quantities that buyers would be willing and
able to purchase at different prices.
Price of
Album
$100 John’s willingness to pay
80 Paul’s willingness to pay
70 George’s willingness to pay
50 Ringo’s willingness to pay
Demand
0 1 2 3 4 Quantity of
Albums
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(a) Price = $80
Price of
Album
$100
John’s consumer surplus ($20)
80
70
50
Demand
0 1 2 3 4 Quantity of
Albums
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(b) Price = $70
Price of
Album
$100
John’s consumer surplus ($30)
80
Paul’s consumer
70 surplus ($10)
Total
50 consumer
surplus ($40)
Demand
0 1 2 3 4 Quantity of
Albums
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The area below the demand curve and above
the price measures the consumer surplus in the
market.
(a) Consumer Surplus at Price P
Price
A
Consumer
surplus
P1
B C
Demand
0 Q1 Quantity
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(b) Consumer Surplus at Price P
Price
A
Initial
consumer
surplus
C Consumer surplus
P1
B to new consumers
F
P2
D E
Additional consumer Demand
surplus to initial
consumers
0 Q1 Q2 Quantity
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Consumer surplus, the amount that buyers are
willing to pay for a good minus the amount
they actually pay for it, measures the benefit
that buyers receive from a good as the buyers
themselves perceive it.
Producer surplus is the amount a seller is paid
for a good minus the seller’s cost.
It measures the benefit to sellers participating
in a market.
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Just as consumer surplus is related to the
demand curve, producer surplus is closely
related to the supply curve.
The area below the price and above the supply
curve measures the producer surplus in a
market.
(a) Price = $600
Price of
House
Painting Supply
$900
800
600
500
Grandma’s producer
surplus ($100)
0 1 2 3 4
Quantity of
Houses Painted
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(b) Price = $800
Price of
House
Painting Supply
Total
producer
$900 surplus ($500)
800
600 Georgia’s producer
500 surplus ($200)
Grandma’s producer
surplus ($300)
0 1 2 3 4
Quantity of
Houses Painted
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(a) Producer Surplus at Price P
Price
Supply
B
P1
C
Producer
surplus
0 Q1 Quantity
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(b) Producer Surplus at Price P
Price
Additional producer Supply
surplus to initial
producers
D E
P2 F
B
P1
Initial C
Producer surplus
producer to new producers
surplus
0 Q1 Q2 Quantity
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Consumer surplus and producer surplus may
be used to address the following question:
Is the allocation of resources determined by free
markets in any way desirable?
Consumer Surplus
= Value to buyers – Amount paid by buyers
and
Producer Surplus
= Amount received by sellers – Cost to sellers
Total surplus
= Consumer surplus + Producer surplus
or
Total surplus
= Value to buyers – Cost to sellers
Efficiency is the property of a resource
allocation of maximizing the total surplus
received by all members of society.
Price A
D
Supply
Consumer
surplus
Equilibrium E
price
Producer
surplus
Demand
B
0 Equilibrium Quantity
quantity
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One possible cause of market failure is an externality.
An externality is the impact of one person’s actions on
the well-being of a passerby. The classic example of an
external cost is pollution.
If a chemical factory does not bear the entire cost of the
smoke it emits, it will likely emit too much. Here, the
government can raise economic well-being through
environmental regulation.
Another possible cause of market failure is market
power.
Market power refers to the ability of a single person
(or small group of people) to unduly influence market
prices. For example, suppose that everyone in town
needs water but there is only one well. The owner of
the well has market power—in this case a monopoly—
over the sale of water.