E S S E N T I A L S O F

E C O N O M I C SF O U R T H E D I T I O N

N. GREGORY MANKIWHARVARD UNIVERSITY

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Essentials of Economics, Fourth EditionN. Gregory Mankiw

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Consumers, Producers, and the Efficiency of Markets

When consumers go to grocery stores to buy their turkeys for Thanksgivingdinner, they may be disappointed that the price of turkey is as high as it is. Atthe same time, when farmers bring to market the turkeys they have raised, theywish the price of turkey were even higher. These views are not surprising: Buy-ers always want to pay less, and sellers always want to get paid more. But isthere a “right price” for turkey from the standpoint of society as a whole?

In previous chapters, we saw how, in market economies, the forces of supplyand demand determine the prices of goods and services and the quantities sold.So far, however, we have described the way markets allocate scarce resourceswithout directly addressing the question of whether these market allocations aredesirable. In other words, our analysis has been positive (what is) rather than nor-mative (what should be). We know that the price of turkey adjusts to ensure thatthe quantity of turkey supplied equals the quantity of turkey demanded. But atthis equilibrium, is the quantity of turkey produced and consumed too small,too large, or just right?

In this chapter, we take up the topic of welfare economics, the study of howthe allocation of resources affects economic well-being. We begin by examiningthe benefits that buyers and sellers receive from taking part in a market. We then

7

137

welfare economicsthe study of how theallocation of resourcesaffects economic well-being

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examine how society can make these benefits as large as possible. This analysisleads to a profound conclusion: The equilibrium of supply and demand in amarket maximizes the total benefits received by buyers and sellers.

As you may recall from Chapter 1, one of the Ten Principles of Economics is thatmarkets are usually a good way to organize economic activity. The study of wel-fare economics explains this principle more fully. It also answers our questionabout the right price of turkey: The price that balances the supply and demandfor turkey is, in a particular sense, the best one because it maximizes the totalwelfare of turkey consumers and turkey producers.

138 PART 3 MARKETS AND WELFARE

11Four Possible Buyers’Willingness to Pay

T A B L E Buyer Willingness to Pay

John $100Paul 80George 70Ringo 50

CONSUMER SURPLUSWe begin our study of welfare economics by looking at the benefits buyersreceive from participating in a market.

Willingness to Pay

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

Four Elvis fans show up for your auction: John, Paul, George, and Ringo.Each of them would like to own the album, but there is a limit to the amountthat each is willing to pay for it. Table 1 shows the maximum price that each ofthe four possible buyers would pay. Each buyer’s maximum is called his will-ingness to pay, and it measures how much that buyer values the good. Eachbuyer would be eager to buy the album at a price less than his willingness topay, and he would refuse to buy the album at a price greater than his willing-ness to pay. At a price equal to his willingness to pay, the buyer would be indif-ferent about buying the good: If the price is exactly the same as the value heplaces on the album, he would be equally happy buying it or keeping hismoney.

To sell your album, you begin the bidding at a low price, say $10. Because allfour buyers are willing to pay much more, the price rises quickly. The biddingstops when John bids $80 (or slightly more). At this point, Paul, George, and

willingness to paythe maximum amountthat a buyer will pay fora good

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Ringo have dropped out of the bidding because they are unwilling to bid anymore than $80. John pays you $80 and gets the album. Note that the album hasgone to the buyer who values the album most highly.

What benefit does John receive from buying the Elvis Presley album? In asense, John has found a real bargain: He is willing to pay $100 for the album butpays only $80 for it. We say that John receives consumer surplus of $20. Con-sumer surplus is the amount a buyer is willing to pay for a good minus theamount the buyer actually pays for it.

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

Now consider a somewhat different example. Suppose that you had two iden-tical Elvis Presley albums to sell. Again, you auction them off to the four possi-ble buyers. To keep things simple, we assume that both albums are to be sold forthe same price and that no buyer is interested in buying more than one album.Therefore, the price rises until two buyers are left.

In this case, the bidding stops when John and Paul bid $70 (or slightlyhigher). At this price, John and Paul are each happy to buy an album, andGeorge and Ringo are not willing to bid any higher. John and Paul each receiveconsumer surplus equal to his willingness to pay minus the price. John’s con-sumer surplus is $30, and Paul’s is $10. John’s consumer surplus is higher nowthan it was previously because he gets the same album but pays less for it. Thetotal consumer surplus in the market is $40.

Using the Demand Curve to Measure Consumer Surplus

Consumer surplus is closely related to the demand curve for a product. To seehow they are related, let’s continue our example and consider the demand curvefor this rare Elvis Presley album.

We begin by using the willingness to pay of the four possible buyers to findthe demand schedule for the album. The table in Figure 1 shows the demandschedule that corresponds to Table 1. If the price is above $100, the quantitydemanded in the market is 0 because no buyer is willing to pay that much. If theprice is between $80 and $100, the quantity demanded is 1 because only John iswilling to pay such a high price. If the price is between $70 and $80, the quantitydemanded is 2 because both John and Paul are willing to pay the price. We cancontinue this analysis for other prices as well. In this way, the demand scheduleis derived from the willingness to pay of the four possible buyers.

The graph in Figure 1 shows the demand curve that corresponds to thisdemand schedule. Note the relationship between the height of the demandcurve and the buyers’ willingness to pay. At any quantity, the price given by thedemand curve shows the willingness to pay of the marginal buyer, the buyerwho would leave the market first if the price were any higher. At a quantity of 4albums, for instance, the demand curve has a height of $50, the price that Ringo(the marginal buyer) is willing to pay for an album. At a quantity of 3 albums,the demand curve has a height of $70, the price that George (who is now themarginal buyer) is willing to pay.

CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 139

consumer surplusthe amount a buyer iswilling to pay for a goodminus the amount thebuyer actually pays for it

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Because the demand curve reflects buyers’ willingness to pay, we can also useit to measure consumer surplus. Figure 2 uses the demand curve to computeconsumer surplus in our example. In panel (a), the price is $80 (or slightlyabove), and the quantity demanded is 1. Note that the area above the price andbelow the demand curve equals $20. This amount is exactly the consumer sur-plus we computed earlier when only 1 album is sold.

Panel (b) of Figure 2 shows consumer surplus when the price is $70 (orslightly above). In this case, the area above the price and below the demandcurve equals the total area of the two rectangles: John’s consumer surplus at thisprice is $30 and Paul’s is $10. This area equals a total of $40. Once again, thisamount is the consumer surplus we computed earlier.

The lesson from this example holds for all demand curves: The area below thedemand curve and above the price measures the consumer surplus in a market. The rea-son is that the height of the demand curve measures the value buyers place onthe good, as measured by their willingness to pay for it. The difference betweenthis willingness to pay and the market price is each buyer’s consumer surplus.Thus, the total area below the demand curve and above the price is the sum ofthe consumer surplus of all buyers in the market for a good or service.

How a Lower Price Raises Consumer Surplus

Because buyers always want to pay less for the goods they buy, a lower pricemakes buyers of a good better off. But how much does buyers’ well-being rise in

140 PART 3 MARKETS AND WELFARE

11The Demand Scheduleand the Demand Curve

F I G U R E The table shows the demand schedule for the buyers in Table 1. The graphshows the corresponding demand curve. Note that the height of thedemand curve reflects buyers’ willingness to pay.

Price ofAlbum

50

70

80

0

$100

Quantity ofAlbums

Demand

1 2 3 4

John’s willingness to pay

Paul’s willingness to pay

George’s willingness to pay

Ringo’s willingness to pay

Quantity Price Buyers Demanded

More than $100 None 0

$80 to $100 John 1

$70 to $80 John, Paul 2

$50 to $70 John, Paul, George 3

$50 or less John, Paul, George, Ringo 4

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response to a lower price? We can use the concept of consumer surplus toanswer this question precisely.

Figure 3 shows a typical demand curve. You may notice that this curve grad-ually slopes downward instead of taking discrete steps as in the previous twofigures. In a market with many buyers, the resulting steps from each buyerdropping out are so small that they form, in essence, a smooth curve. Althoughthis curve has a different shape, the ideas we have just developed still apply:Consumer surplus is the area above the price and below the demand curve. Inpanel (a), consumer surplus at a price of P1 is the area of triangle ABC.

Now suppose that the price falls from P1 to P2, as shown in panel (b). The con-sumer surplus now equals area ADF. The increase in consumer surplus attribut-able to the lower price is the area BCFD.

This increase in consumer surplus is composed of two parts. First, those buy-ers who were already buying Q1 of the good at the higher price P1 are better offbecause they now pay less. The increase in consumer surplus of existing buyersis the reduction in the amount they pay; it equals the area of the rectangle BCED.Second, some new buyers enter the market because they are now willing to buythe good at the lower price. As a result, the quantity demanded in the marketincreases from Q1 to Q2. The consumer surplus these newcomers receive is thearea of the triangle CEF.

CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 141

22F I G U R E

Measuring Consumer Surpluswith the Demand Curve

In panel (a), the price of the good is $80, and the consumer surplus is$20. In panel (b), the price of the good is $70, and the consumer sur-plus is $40.

(b) Price = $70Price of

Album

50

70

80

0

$100

Demand

1 2 3 4

Totalconsumersurplus ($40)

Quantity ofAlbums

John’s consumer surplus ($30)

Paul’s consumersurplus ($10)

(a) Price = $80

Price ofAlbum

50

70

80

0

$100

Demand

1 2 3 4 Quantity ofAlbums

John’s consumer surplus ($20)

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What Does Consumer Surplus Measure?

Our goal in developing the concept of consumer surplus is to make judg-ments about the desirability of market outcomes. Now that you have seenwhat consumer surplus is, let’s consider whether it is a good measure of eco-nomic well-being.

Imagine that you are a policymaker trying to design a good economic system.Would you care about the amount of consumer surplus? Consumer surplus, theamount that buyers are willing to pay for a good minus the amount they actu-ally pay for it, measures the benefit that buyers receive from a good as the buyersthemselves perceive it. Thus, consumer surplus is a good measure of economicwell-being if policymakers want to respect the preferences of buyers.

In some circumstances, policymakers might choose not to care about con-sumer surplus because they do not respect the preferences that drive buyerbehavior. For example, drug addicts are willing to pay a high price for heroin.Yet we would not say that addicts get a large benefit from being able to buyheroin at a low price (even though addicts might say they do). From the stand-point of society, willingness to pay in this instance is not a good measure of thebuyers’ benefit, and consumer surplus is not a good measure of economic well-being, because addicts are not looking after their own best interests.

142 PART 3 MARKETS AND WELFARE

33How the Price AffectsConsumer Surplus

F I G U R E In panel (a), the price is P1, the quantity demanded is Q1, and consumer sur-plus equals the area of the triangle ABC. When the price falls from P1 to P2,as in panel (b), the quantity demanded rises from Q1 to Q2, and the consumersurplus rises to the area of the triangle ADF. The increase in consumer surplus(area BCFD) occurs in part because existing consumers now pay less (areaBCED) and in part because new consumers enter the market at the lowerprice (area CEF).

Quantity

(a) Consumer Surplus at Price P1

Price

0

Demand

P1

A

B C

Consumersurplus

Q1 Quantity

(b) Consumer Surplus at Price P2

Price

0

Demand

P1

P2

A

B

Initialconsumersurplus

D

C

EF

Q1 Q2

Consumer surplusto new consumers

Additional consumersurplus to initial consumers

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In most markets, however, consumer surplus does reflect economic well-being. Economists normally assume that buyers are rational when they makedecisions. Rational people do the best they can to achieve their objectives, giventheir opportunities. Economists also normally assume that people’s preferencesshould be respected. In this case, consumers are the best judges of how muchbenefit they receive from the goods they buy.

Draw a demand curve for turkey. In your diagram, show a price ofturkey and the consumer surplus that results from that price. Explain in words what thisconsumer surplus measures.

CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 143

22T A B L E

The Costs of Four Possible Sellers

Seller Cost

Mary $900Frida 800Georgia 600Grandma 500

costthe value of everything aseller must give up toproduce a good

PRODUCER SURPLUSWe now turn to the other side of the market and consider the benefits sellersreceive from participating in a market. As you will see, our analysis of sellers’welfare is similar to our analysis of buyers’ welfare.

Cost and the Willingness to Sell

Imagine now that you are a homeowner, and you need to get your housepainted. You turn to four sellers of painting services: Mary, Frida, Georgia, andGrandma. Each painter is willing to do the work for you if the price is right. Youdecide to take bids from the four painters and auction off the job to the painterwho will do the work for the lowest price.

Each painter is willing to take the job if the price she would receive exceedsher cost of doing the work. Here the term cost should be interpreted as thepainters’ opportunity cost: It includes the painters’ out-of-pocket expenses (forpaint, brushes, and so on) as well as the value that the painters place on theirown time. Table 2 shows each painter’s cost. Because a painter’s cost is the low-est price she would accept for her work, cost is a measure of her willingness tosell her services. Each painter would be eager to sell her services at a pricegreater than her cost, and she would refuse to sell her services at a price lessthan her cost. At a price exactly equal to her cost, she would be indifferent aboutselling her services: She would be equally happy getting the job or walkingaway without incurring the cost.

When you take bids from the painters, the price might start off high, but itquickly falls as the painters compete for the job. Once Grandma has bid $600 (orslightly less), she is the sole remaining bidder. Grandma is happy to do the job

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for this price because her cost is only $500. Mary, Frida, and Georgia are unwill-ing to do the job for less than $600. Note that the job goes to the painter who cando the work at the lowest cost.

What benefit does Grandma receive from getting the job? Because she is will-ing to do the work for $500 but gets $600 for doing it, we say that she receivesproducer surplus of $100. Producer surplus is the amount a seller is paid minusthe cost of production. Producer surplus measures the benefit to sellers of partic-ipating in a market.

Now consider a somewhat different example. Suppose that you have twohouses that need painting. Again, you auction off the jobs to the four painters.To keep things simple, let’s assume that no painter is able to paint both housesand that you will pay the same amount to paint each house. Therefore, the pricefalls until two painters are left.

In this case, the bidding stops when Georgia and Grandma each offer to do thejob for a price of $800 (or slightly less). At this price, Georgia and Grandma arewilling to do the work, and Mary and Frida are not willing to bid a lower price. Ata price of $800, Grandma receives producer surplus of $300, and Georgia receivesproducer surplus of $200. The total producer surplus in the market is $500.

Using the Supply Curve to Measure Producer Surplus

Just as consumer surplus is closely related to the demand curve, producer sur-plus is closely related to the supply curve. To see how, let’s continue our example.

We begin by using the costs of the four painters to find the supply schedulefor painting services. The table in Figure 4 shows the supply schedule that corre-

144 PART 3 MARKETS AND WELFARE

producer surplusthe amount a seller ispaid for a good minusthe seller’s cost of pro-viding it

44The Supply Scheduleand the Supply Curve

F I G U R E The table shows the supply schedule for the sellers in Table 2. The graphshows the corresponding supply curve. Note that the height of the supplycurve reflects sellers’ costs.

Price ofHouse

Painting

500

800

$900

0 Quantity ofHouses Painted

600

1 2 3 4

Supply

Mary’s cost

Frida’s cost

Georgia’s cost

Grandma’s cost

Quantity Price Sellers Supplied

$900 or more Mary, Frida, 4Georgia, Grandma

$800 to $900 Frida, Georgia, 3Grandma

$600 to $800 Georgia, Grandma 2

$500 to $600 Grandma 1

Less than $500 None 0

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sponds to the costs in Table 2. If the price is below $500, none of the fourpainters is willing to do the job, so the quantity supplied is zero. If the price isbetween $500 and $600, only Grandma is willing to do the job, so the quantitysupplied is 1. If the price is between $600 and $800, Grandma and Georgia arewilling to do the job, so the quantity supplied is 2, and so on. Thus, the supplyschedule is derived from the costs of the four painters.

The graph in Figure 4 shows the supply curve that corresponds to this supplyschedule. Note that the height of the supply curve is related to the sellers’ costs.At any quantity, the price given by the supply curve shows the cost of the mar-ginal seller, the seller who would leave the market first if the price were anylower. At a quantity of 4 houses, for instance, the supply curve has a height of$900, the cost that Mary (the marginal seller) incurs to provide her painting ser-vices. At a quantity of 3 houses, the supply curve has a height of $800, the costthat Frida (who is now the marginal seller) incurs.

Because the supply curve reflects sellers’ costs, we can use it to measure pro-ducer surplus. Figure 5 uses the supply curve to compute producer surplus inour example. In panel (a), we assume that the price is $600. In this case, thequantity supplied is 1. Note that the area below the price and above the supplycurve equals $100. This amount is exactly the producer surplus we computedearlier for Grandma.

Panel (b) of Figure 5 shows producer surplus at a price of $800. In this case,the area below the price and above the supply curve equals the total area of the

CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 145

55F I G U R E

Measuring Producer Surpluswith the Supply Curve

In panel (a), the price of the good is $600, and the producer surplus is$100. In panel (b), the price of the good is $800, and the producersurplus is $500.

Quantity ofHouses Painted

Quantity ofHouses Painted

Price ofHouse

Painting

500

800

$900

0

Supply

600

1 2 3 4

(b) Price = $800

Price ofHouse

Painting

500

800

$900

0

600

1 2 3 4

(a) Price = $600

Supply

Grandma’s producersurplus ($100)

Georgia’s producersurplus ($200)

Totalproducersurplus ($500)

Grandma’s producersurplus ($300)

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two rectangles. This area equals $500, the producer surplus we computed earlierfor Georgia and Grandma when two houses needed painting.

The lesson from this example applies to all supply curves: The area below theprice and above the supply curve measures the producer surplus in a market. The logic isstraightforward: The height of the supply curve measures sellers’ costs, and thedifference between the price and the cost of production is each seller’s producersurplus. Thus, the total area is the sum of the producer surplus of all sellers.

How a Higher Price Raises Producer Surplus

You will not be surprised to hear that sellers always want to receive a higherprice for the goods they sell. But how much does sellers’ well-being rise inresponse to a higher price? The concept of producer surplus offers a preciseanswer to this question.

Figure 6 shows a typical upward-sloping supply curve that would arise in amarket with many sellers. Although this supply curve differs in shape from theprevious figure, we measure producer surplus in the same way: Producer sur-plus is the area below the price and above the supply curve. In panel (a), theprice is P1, and producer surplus is the area of triangle ABC.

Panel (b) shows what happens when the price rises from P1 to P2. Producersurplus now equals area ADF. This increase in producer surplus has two parts.

146 PART 3 MARKETS AND WELFARE

66How the Price AffectsProducer Surplus

F I G U R E In panel (a), the price is P1, the quantity demanded is Q1, and producer sur-plus equals the area of the triangle ABC. When the price rises from P1 to P2,as in panel (b), the quantity supplied rises from Q1 to Q2, and the producersurplus rises to the area of the triangle ADF. The increase in producer surplus(area BCFD) occurs in part because existing producers now receive more (areaBCED) and in part because new producers enter the market at the higherprice (area CEF).

Quantity

(b) Producer Surplus at Price P2

Quantity

(a) Producer Surplus at Price P1

Price

0

Supply

B

A

CProducersurplus

Q1

Price

0

P2

P1B

CP1

Supply

A

D

Initialproducersurplus

EF

Q1 Q2

Producer surplusto new producers

Additional producersurplus to initialproducers

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First, those sellers who were already selling Q1 of the good at the lower price P1are better off because they now get more for what they sell. The increase in pro-ducer surplus for existing sellers equals the area of the rectangle BCED. Second,some new sellers enter the market because they are now willing to produce thegood at the higher price, resulting in an increase in the quantity supplied fromQ1 to Q2. The producer surplus of these newcomers is the area of the triangleCEF.

As this analysis shows, we use producer surplus to measure the well-being ofsellers in much the same way as we use consumer surplus to measure the well-being of buyers. Because these two measures of economic welfare are so similar,it is natural to use them together. And indeed, that is exactly what we do in thenext section.

Draw a supply curve for turkey. In your diagram, show a price ofturkey and the producer surplus that results from that price. Explain in words what thisproducer surplus measures.

CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 147

MARKET EFFICIENCYConsumer surplus and producer surplus are the basic tools that economists useto study the welfare of buyers and sellers in a market. These tools can help usaddress a fundamental economic question: Is the allocation of resources deter-mined by free markets desirable?

The Benevolent Social Planner

To evaluate market outcomes, we introduce into our analysis a new, hypotheticalcharacter called the benevolent social planner. The benevolent social planner isan all-knowing, all-powerful, well-intentioned dictator. The planner wants tomaximize the economic well-being of everyone in society. What do you supposethis planner should do? Should he just leave buyers and sellers at the equilib-rium that they reach naturally on their own? Or can he increase economic well-being by altering the market outcome in some way?

To answer this question, the planner must first decide how to measure theeconomic well-being of a society. One possible measure is the sum of consumerand producer surplus, which we call total surplus. Consumer surplus is the bene-fit that buyers receive from participating in a market, and producer surplus isthe benefit that sellers receive. It is therefore natural to use total surplus as ameasure of society’s economic well-being.

To better understand this measure of economic well-being, recall how we mea-sure consumer and producer surplus. We define consumer surplus as

Consumer surplus � Value to buyers � Amount paid by buyers.

Similarly, we define producer surplus as

Producer surplus � Amount received by sellers � Cost to sellers.

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When we add consumer and producer surplus together, we obtain

Total surplus � Value to buyers � Amount paid by buyers� Amount received by sellers � Cost to sellers.

The amount paid by buyers equals the amount received by sellers, so the middletwo terms in this expression cancel each other. As a result, we can write totalsurplus as

Total surplus � Value to buyers � Cost to sellers.

Total surplus in a market is the total value to buyers of the goods, as measuredby their willingness to pay, minus the total cost to sellers of providing thosegoods.

If an allocation of resources maximizes total surplus, we say that the alloca-tion exhibits efficiency. If an allocation is not efficient, then some of the gainsfrom trade among buyers and sellers are not being realized. For example, anallocation is inefficient if a good is not being produced by the sellers with lowestcost. In this case, moving production from a high-cost producer to a low-costproducer will lower the total cost to sellers and raise total surplus. Similarly, anallocation is inefficient if a good is not being consumed by the buyers who valueit most highly. In this case, moving consumption of the good from a buyer witha low valuation to a buyer with a high valuation will raise total surplus.

In addition to efficiency, the social planner might also care about equity—thefairness of the distribution of well-being among the various buyers and sellers.In essence, the gains from trade in a market are like a pie to be distributedamong the market participants. The question of efficiency is whether the pie isas big as possible. The question of equity is whether the pie is divided fairly.Evaluating the equity of a market outcome is more difficult than evaluating theefficiency. Whereas efficiency is an objective goal that can be judged on strictlypositive grounds, equity involves normative judgments that go beyond econom-ics and enter into the realm of political philosophy.

In this chapter, we concentrate on efficiency as the social planner’s goal. Keepin mind, however, that real policymakers often care about equity as well. That is,they care about both the size of the economic pie and how the pie gets slicedand distributed among members of society.

Evaluating the Market Equilibrium

Figure 7 shows consumer and producer surplus when a market reaches the equi-librium of supply and demand. Recall that consumer surplus equals the areaabove the price and under the demand curve and producer surplus equals thearea below the price and above the supply curve. Thus, the total area betweenthe supply and demand curves up to the point of equilibrium represents thetotal surplus in this market.

Is this equilibrium allocation of resources efficient? Does it maximize totalsurplus? To answer these questions, keep in mind that when a market is in equi-librium, the price determines which buyers and sellers participate in the market.Those buyers who value the good more than the price (represented by the seg-ment AE on the demand curve) choose to buy the good; buyers who value it lessthan the price (represented by the segment EB) do not. Similarly, those sellers

148 PART 3 MARKETS AND WELFARE

efficiencythe property of aresource allocation ofmaximizing the total sur-plus received by allmembers of society

equitythe fairness of the dis-tribution of well-beingamong the members ofsociety

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whose costs are less than the price (represented by the segment CE on the sup-ply curve) choose to produce and sell the good; sellers whose costs are greaterthan the price (represented by the segment ED) do not.

These observations lead to two insights about market outcomes:

1. Free markets allocate the supply of goods to the buyers who value themmost highly, as measured by their willingness to pay.

2. Free markets allocate the demand for goods to the sellers who can producethem at least cost.

Thus, given the quantity produced and sold in a market equilibrium, the socialplanner cannot increase economic well-being by changing the allocation of con-sumption among buyers or the allocation of production among sellers.

But can the social planner raise total economic well-being by increasing ordecreasing the quantity of the good? The answer is no, as stated in this thirdinsight about market outcomes:

3. Free markets produce the quantity of goods that maximizes the sum of con-sumer and producer surplus.

Figure 8 illustrates why this is true. To interpret this figure, keep in mind thatthe demand curve reflects the value to buyers and the supply curve reflects thecost to sellers. At any quantity below the equilibrium level, such as Q1, the valueto the marginal buyer exceeds the cost to the marginal seller. As a result, increas-ing the quantity produced and consumed raises total surplus. This continues to

CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 149

77F I G U R E

Consumer and Producer Surplusin the Market EquilibriumTotal surplus—the sum of consumerand producer surplus—is the areabetween the supply and demandcurves up to the equilibrium quantity.

Price

Equilibriumprice

0 QuantityEquilibriumquantity

A

Supply

C

BDemand

D

Producersurplus

Consumersurplus

E

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be true until the quantity reaches the equilibrium level. Similarly, at any quantityabove the equilibrium level, such as Q2, the value to the marginal buyer is lessthan the cost to the marginal seller. In this case, decreasing the quantity raisestotal surplus, and this continues to be true until quantity falls to the equilibriumlevel. To maximize total surplus, the social planner would choose the quantitywhere the supply and demand curves intersect.

Together, these three insights tell us that the market outcome makes the sumof consumer and producer surplus as large as it can be. In other words, the equi-librium outcome is an efficient allocation of resources. The benevolent socialplanner can, therefore, leave the market outcome just as he finds it. This policyof leaving well enough alone goes by the French expression laissez faire, whichliterally translated means “allow them to do.”

Society is lucky that the planner doesn’t need to intervene. Although it has beena useful exercise imagining what an all-knowing, all-powerful, well-intentioneddictator would do, let’s face it: Such characters are hard to come by. Dictators arerarely as benevolent as our assumed one. And even if we found someone so virtu-ous, he would lack crucial information.

Suppose our social planner tried to choose an efficient allocation of resourceson his own, instead of relying on market forces. To do so, he would need toknow the willingness to pay of every potential buyer in the market and the costof every potential seller. And he would need this information not only for thismarket but for every one of the many thousands of markets in the economy. Thetask is practically impossible, which explains why centrally planned economiesnever work very well.

150 PART 3 MARKETS AND WELFARE

88The Efficiency of the Equilibrium QuantityAt quantities less than the equilibrium quantity,such as Q1, the value to buyers exceeds thecost to sellers. At quantities greater than theequilibrium quantity, such as Q2, the cost tosellers exceeds the value to buyers. Therefore,the market equilibrium maximizes the sum ofproducer and consumer surplus.

F I G U R E

Quantity

Price

0 Equilibriumquantity

Supply

Demand

Costto

sellers

Costto

sellers

Valueto

buyers

Valueto

buyers

Value to buyers is greaterthan cost to sellers.

Value to buyers is lessthan cost to sellers.

Q1 Q2

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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 151

In The NewsTicket ScalpingTo allocate resources efficiently, an economy must get goods tothe consumers who value them most highly. Sometimes this jobfalls to ticket scalpers.

Tickets? Supply MeetsDemand on SidewalkBy John Tierney

Ticket scalping has been very good toKevin Thomas, and he makes no apolo-gies. He sees himself as a classic Ameri-can entrepreneur: a high school dropoutfrom the Bronx who taught himself atrade, works seven nights a week, earns$40,000 a year, and at age twenty-sixhas $75,000 in savings, all by providinga public service outside New York’s the-aters and sports arenas.

He has just one complaint. “I’vebeen busted about 30 times in the lastyear,” he said one recent evening, justafter making $280 at a Knicks game.“You learn to deal with it—I give thecops a fake name, and I pay the fineswhen I have to, but I don’t think it’s fair.I look at scalping like working as astockbroker, buying low and selling high.If people are willing to pay me themoney, what kind of problem is that?”

It is a significant problem to publicofficials in New York and New Jersey,who are cracking down on streetscalpers like Mr. Thomas and on licensedticket brokers. Undercover officers areenforcing new restrictions on resellingtickets at marked-up prices, and the at-

Source: The New York Times, December 26, 1992, page A1.

torneys general of the two states arepressing well-publicized cases againstmore than a dozen ticket brokers.

But economists tend to see scalpingfrom Mr. Thomas’s perspective. To them,the governments’ crusade makes aboutas much sense as the old campaigns byCommunist authorities against “profi-teering.” Economists argue that the re-strictions inconvenience the public, re-duce the audience for cultural andsports events, waste the police’s time,deprive New York City of tens of millionsof dollars of tax revenue, and actuallydrive up the cost of many tickets.

“It is always good politics to pose asdefender of the poor by declaring highprices illegal,” says William J. Baumol,the director of the C. V. Starr Center forApplied Economics at New York Univer-sity. . . . “But when you outlaw highprices you create real problems.”. . .

Economists see an illustration of thatlesson at the Museum of Modern Art,where people wait in line for up to twohours to buy tickets for the Matisse ex-hibit. But there is an alternative on thesidewalk: Scalpers who evade the policehave been selling the $12.50 tickets tothe show at prices ranging from $20 to$50.

“You don’t have to put a very highvalue on your time to pay $10 or $15 toavoid standing in line for two hours fora Matisse ticket,” said Richard H. Thaler,an economist at Cornell University.“Some people think it’s fairer to makeeveryone stand in line, but that forceseveryone to engage in a totally unpro-ductive activity, and it discriminates infavor of people who have the most freetime. Scalping gives other people achance, too. I can see no justification foroutlawing it.”. . .

Legalizing scalping, however, wouldnot necessarily be good news for every-one. Mr. Thomas, for instance, fears thatthe extra competition might put him outof business. But after 16 years—hestarted at age ten outside of Yankee Sta-dium—he is thinking it might be timefor a change anyway.

PH

OTO

:©R

OB

IN N

ELS

ON

/PH

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ED

IT

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The planner’s job becomes easy, however, once he takes on a partner: AdamSmith’s invisible hand of the marketplace. The invisible hand takes all the infor-mation about buyers and sellers into account, guiding everyone in the market tothe best outcome as judged by the standard of economic efficiency. It is, truly, aremarkable feat. That is why economists so often advocate free markets as thebest way to organize economic activity.

SHOULD THERE BE A MARKET IN ORGANS?

On April 12, 2001, the front page of The Boston Globe ran the headline “How aMother’s Love Helped Save Two Lives.” The newspaper told the story of SusanStephens, a woman whose son needed a kidney transplant. When the doctorlearned that the mother’s kidney was not compatible, he proposed a novel solu-tion: If Stephens donated one of her kidneys to a stranger, her son would moveto the top of the kidney waiting list. The mother accepted the deal, and soon twopatients had the transplant they were waiting for.

The ingenuity of the doctor’s proposal and the nobility of the mother’s actcannot be doubted. But the story raises some intriguing questions. If the mothercould trade a kidney for a kidney, would the hospital allow her to trade a kidneyfor an expensive, experimental cancer treatment that she could not afford other-wise? Should she be allowed to exchange her kidney for free tuition for her sonat the hospital’s medical school? Should she be able to sell her kidney so she canuse the cash to trade in her old Chevy for a new Lexus?

As a matter of public policy, people are not allowed to sell their organs. Inessence, in the market for organs, the government has imposed a price ceiling ofzero. The result, as with any binding price ceiling, is a shortage of the good. Thedeal in the Stephens case did not fall under this prohibition because no cashchanged hands.

Many economists believe that there would be large benefits to allowing a freemarket in organs. People are born with two kidneys, but they usually need onlyone. Meanwhile, a few people suffer from illnesses that leave them without anyworking kidney. Despite the obvious gains from trade, the current situation isdire: The typical patient has to wait several years for a kidney transplant, andthousands of people die every year because a kidney cannot be found. If thoseneeding a kidney were allowed to buy one from those who have two, the pricewould rise to balance supply and demand. Sellers would be better off with theextra cash in their pockets. Buyers would be better off with the organ they needto save their lives. The shortage of kidneys would disappear.

Such a market would lead to an efficient allocation of resources, but critics ofthis plan worry about fairness. A market for organs, they argue, would benefit therich at the expense of the poor because organs would then be allocated to thosemost willing and able to pay. But you can also question the fairness of the currentsystem. Now, most of us walk around with an extra organ that we don’t reallyneed, while some of our fellow citizens are dying to get one. Is that fair? •

Draw the supply and demand for turkey. In the equilibrium, showproducer and consumer surplus. Explain why producing more turkeys would lower totalsurplus.

152 PART 3 MARKETS AND WELFARE

C A S ESTUDY

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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 153

In The NewsThe Miracle of the MarketAn opinion columnist suggests that the next time you sit downfor Thanksgiving dinner, you should give thanks not only for theturkey on your plate but also for the economic system in whichyou live.

Giving Thanks for the“Invisible Hand”By Jeff Jacoby

Gratitude to the Almighty is the themeof Thanksgiving, and has been eversince the Pilgrims of Plymouth broughtin their first good harvest. . . . Today, inmillions of homes across the nation,God will be thanked for many gifts—forthe feast on the table and the companyof loved ones, for health and good for-tune in the year gone by, for peace athome in a time of war, for the incalcula-ble privilege of having been born—orhaving become—American.

But it probably won’t occur to toomany of us to give thanks for the factthat the local supermarket had plenty ofturkey for sale this week. Even the de-vout aren’t likely to thank God for air-line schedules that made it possible forsome of those loved ones to fly homefor Thanksgiving. Or for the arrival of“Master and Commander” at the localmovie theater in time for the holidayweekend. Or for that great cranberry-apple pie recipe in the food section ofthe newspaper.

Those things we take more or lessfor granted. It hardly takes a miracle toexplain why grocery stores stock up onturkey before Thanksgiving, or why Hol-lywood releases big movies in time forbig holidays. That’s what they do. Whereis God in that?

Source: The Boston Globe, November 27, 2003.

And yet, isn’t there something won-drous—something almost inexplicable—in the way your Thanksgiving weekendis made possible by the skill and laborof vast numbers of total strangers?

To bring that turkey to the diningroom table, for example, required the ef-forts of thousands of people—the poul-try farmers who raised the birds, ofcourse, but also the feed distributorswho supplied their nourishment and thetruckers who brought it to the farm, notto mention the architect who designedthe hatchery, the workmen who built it,and the technicians who keep it run-ning. The bird had to be slaughtered anddefeathered and inspected and trans-ported and unloaded and wrapped andpriced and displayed. The people whoaccomplished those tasks were sup-ported in turn by armies of other peopleaccomplishing other tasks—from refin-ing the gasoline that fueled the trucksto manufacturing the plastic in whichthe meat was packaged.

The activities of countless far-flungmen and women over the course ofmany months had to be intricately cho-reographed and precisely timed, so thatwhen you showed up to buy a freshThanksgiving turkey, there would beone—or more likely, a few dozen—waiting. The level of coordination thatwas required to pull it off is mind-boggling. But what is even more mind-boggling is this: No one coordinated it.

No turkey czar sat in a commandpost somewhere, consulting a masterplan and issuing orders. No one rodeherd on all those people, forcing themto cooperate for your benefit. And yetthey did cooperate. When you arrived atthe supermarket, your turkey was there.You didn’t have to do anything butshow up to buy it. If that isn’t a miracle,what should we call it?

Adam Smith called it “the invisiblehand”—the mysterious power thatleads innumerable people, each workingfor his own gain, to promote ends thatbenefit many. Out of the seeming chaosof millions of uncoordinated privatetransactions emerges the spontaneousorder of the market. Free human beingsfreely interact, and the result is an arrayof goods and services more immensethan the human mind can comprehend.No dictator, no bureaucracy, no super-computer plans it in advance. Indeed,the more an economy is planned, themore it is plagued by shortages, disloca-tion, and failure. . . .

The social order of freedom, like thewealth and the progress it makes possi-ble, is an extraordinary gift from above.On this Thanksgiving Day and every day,may we be grateful.

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154 PART 3 MARKETS AND WELFARE

CONCLUSION: MARKET EFFICIENCY AND MARKET FAILUREThis chapter introduced the basic tools of welfare economics—consumer andproducer surplus—and used them to evaluate the efficiency of free markets. Weshowed that the forces of supply and demand allocate resources efficiently. Thatis, even though each buyer and seller in a market is concerned only about his orher own welfare, they are together led by an invisible hand to an equilibriumthat maximizes the total benefits to buyers and sellers.

A word of warning is in order. To conclude that markets are efficient, wemade several assumptions about how markets work. When these assumptionsdo not hold, our conclusion that the market equilibrium is efficient may nolonger be true. As we close this chapter, let’s consider briefly two of the mostimportant of these assumptions.

First, our analysis assumed that markets are perfectly competitive. In theworld, however, competition is sometimes far from perfect. In some markets, asingle buyer or seller (or a small group of them) may be able to control marketprices. This ability to influence prices is called market power. Market power cancause markets to be inefficient because it keeps the price and quantity awayfrom the equilibrium of supply and demand.

Second, our analysis assumed that the outcome in a market matters only tothe buyers and sellers in that market. Yet, in the world, the decisions of buyersand sellers sometimes affect people who are not participants in the market at all.Pollution is the classic example of a market outcome that affects people not inthe market. Such side effects, called externalities, cause welfare in a market todepend on more than just the value to the buyers and the cost to the sellers.Because buyers and sellers do not take these side effects into account whendeciding how much to consume and produce, the equilibrium in a market canbe inefficient from the standpoint of society as a whole.

Market power and externalities are examples of a general phenomenon calledmarket failure—the inability of some unregulated markets to allocate resourcesefficiently. When markets fail, public policy can potentially remedy the problemand increase economic efficiency. Microeconomists devote much effort to study-ing when market failure is likely and what sorts of policies are best at correctingmarket failures. As you continue your study of economics, you will see that thetools of welfare economics developed here are readily adapted to that endeavor.

Despite the possibility of market failure, the invisible hand of the marketplaceis extraordinarily important. In many markets, the assumptions we made in thischapter work well, and the conclusion of market efficiency applies directly.Moreover, our analysis of welfare economics and market efficiency can be usedto shed light on the effects of various government policies. In the next two chap-ters, we apply the tools we have just developed to study two important policyissues—the welfare effects of taxation and of international trade.

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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 155

1. Explain how buyers’ willingness to pay, con-sumer surplus, and the demand curve are related.

2. Explain how sellers’ costs, producer surplus, andthe supply curve are related.

3. In a supply-and-demand diagram, show producerand consumer surplus in the market equilibrium.

4. What is efficiency? Is it the only goal of economicpolicymakers?

5. What does the invisible hand do?6. Name two types of market failure. Explain why

each may cause market outcomes to be inefficient.

QUESTIONS FOR REVIEW

welfare economics, p. 137willingness to pay, p. 138consumer surplus, p. 139

efficiency, p. 148equity, p. 148

KEY CONCEPTS

cost, p. 143producer surplus, p. 144

• Consumer surplus equals buyers’ willingness topay for a good minus the amount they actuallypay for it, and it measures the benefit buyers getfrom participating in a market. Consumer sur-plus can be computed by finding the area belowthe demand curve and above the price.

• Producer surplus equals the amount sellersreceive for their goods minus their costs of pro-duction, and it measures the benefit sellers getfrom participating in a market. Producer surpluscan be computed by finding the area below theprice and above the supply curve.

• An allocation of resources that maximizes thesum of consumer and producer surplus is said to

be efficient. Policymakers are often concernedwith the efficiency, as well as the equity, of eco-nomic outcomes.

• The equilibrium of supply and demand maxi-mizes the sum of consumer and producer sur-plus. That is, the invisible hand of the market-place leads buyers and sellers to allocateresources efficiently.

• Markets do not allocate resources efficiently inthe presence of market failures such as marketpower or externalities.

SUMMARY

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156 PART 3 MARKETS AND WELFARE

1. An early freeze in California sours the lemoncrop. Explain what happens to consumer surplusin the market for lemons. Explain what happensto consumer surplus in the market for lemon-ade. Illustrate your answers with diagrams.

2. Suppose the demand for French bread rises.Explain what happens to producer surplus inthe market for French bread. Explain what hap-pens to producer surplus in the market for flour.Illustrate your answers with diagrams.

3. It is a hot day, and Bert is thirsty. Here is thevalue he places on a bottle of water:

Value of first bottle $ 7Value of second bottle $ 5Value of third bottle $ 3Value of fourth bottle $ 1

a. From this information, derive Bert’s demandschedule. Graph his demand curve for bot-tled water.

b. If the price of a bottle of water is $4, howmany bottles does Bert buy? How much con-sumer surplus does Bert get from his pur-chases? Show Bert’s consumer surplus inyour graph.

c. If the price falls to $2, how does quantitydemanded change? How does Bert’s con-sumer surplus change? Show these changesin your graph.

4. Ernie owns a water pump. Because pumpinglarge amounts of water is harder than pumpingsmall amounts, the cost of producing a bottle ofwater rises as he pumps more. Here is the costhe incurs to produce each bottle of water:

Cost of first bottle $ 1Cost of second bottle $ 3Cost of third bottle $ 5Cost of fourth bottle $ 7

a. From this information, derive Ernie’s supplyschedule. Graph his supply curve for bottledwater.

b. If the price of a bottle of water is $4, howmany bottles does Ernie produce and sell?

How much producer surplus does Ernie getfrom these sales? Show Ernie’s producer sur-plus in your graph.

c. If the price rises to $6, how does quantitysupplied change? How does Ernie’s producersurplus change? Show these changes in yourgraph.

5. Consider a market in which Bert from Problem 3is the buyer and Ernie from Problem 4 is theseller.a. Use Ernie’s supply schedule and Bert’s

demand schedule to find the quantity sup-plied and quantity demanded at prices of $2,$4, and $6. Which of these prices brings sup-ply and demand into equilibrium?

b. What are consumer surplus, producer sur-plus, and total surplus in this equilibrium?

c. If Ernie produced and Bert consumed onefewer bottle of water, what would happen tototal surplus?

d. If Ernie produced and Bert consumed oneadditional bottle of water, what would hap-pen to total surplus?

6. The cost of producing stereo systems has fallenover the past several decades. Let’s considersome implications of this fact.a. Draw a supply-and-demand diagram to

show the effect of falling production costs onthe price and quantity of stereos sold.

b. In your diagram, show what happens to con-sumer surplus and producer surplus.

c. Suppose the supply of stereos is very elastic.Who benefits most from falling productioncosts—consumers or producers of stereos?

7. There are four consumers willing to pay the fol-lowing amounts for haircuts:Jerry: $7 Oprah: $2 Ellen: $8 Phil: $5

There are four haircutting businesses with thefollowing costs:Firm A: $3 Firm B: $6 Firm C: $4 Firm D: $2

Each firm has the capacity to produce only onehaircut. For efficiency, how many haircuts

PROBLEMS AND APPLICATIONS

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CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 157

should be given? Which businesses should cuthair and which consumers should have theirhair cut? How large is the maximum possibletotal surplus?

8. Suppose a technological advance reduces thecost of making computers.a. Draw a supply-and-demand diagram to

show what happens to price, quantity, con-sumer surplus, and producer surplus in themarket for computers.

b. Computers and adding machines are substi-tutes. Use a supply-and-demand diagram toshow what happens to price, quantity, con-sumer surplus, and producer surplus in themarket for adding machines. Should addingmachine producers be happy or sad aboutthe technological advance in computers?

c. Computers and software are complements.Draw a supply-and-demand diagram to showwhat happens to price, quantity, consumersurplus, and producer surplus in the marketfor software. Should software producers behappy or sad about the technological advancein computers?

d. Does this analysis help explain why softwareproducer Bill Gates is one of the world’s rich-est men?

9. Consider how health insurance affects the quan-tity of healthcare services performed. Supposethat the typical medical procedure has a cost of$100, yet a person with health insurance paysonly $20 out of pocket. Her insurance companypays the remaining $80. (The insurance com-pany recoups the $80 through premiums, butthe premium a person pays does not depend onhow many procedures that person chooses toundertake.)a. Draw the demand curve in the market for

medical care. (In your diagram, the horizon-tal axis should represent the number of med-ical procedures.) Show the quantity of proce-dures demanded if each procedure has aprice of $100.

b. On your diagram, show the quantity of pro-cedures demanded if consumers pay only $20per procedure. If the cost of each procedure

to society is truly $100, and if individualshave health insurance as just described, willthe number of procedures performed maxi-mize total surplus? Explain.

c. Economists often blame the health insurancesystem for excessive use of medical care.Given your analysis, why might the use ofcare be viewed as “excessive”?

d. What sort of policies might prevent thisexcessive use?

10. Many parts of California experienced a severedrought in the late 1980s and early 1990s.a. Draw a diagram of the water market to show

the effects of the drought on the equilibriumprice and quantity of water.

b. Many communities did not allow the price ofwater to change, however. What is the effectof this policy on the water market? Show onyour diagram any surplus or shortage thatarises.

c. A 1991 op-ed piece in The Wall Street Journalstated that “all Los Angeles residents arerequired to cut their water usage by 10 per-cent as of March 1 and another 5 percentstarting May 1, based on their 1986 consump-tion levels.” The author criticized this policyon the grounds of both efficiency and equity,saying “not only does such a policy rewardfamilies who ‘wasted’ more water back in1986, it does little to encourage consumerswho could make more drastic reductions,[and] . . . punishes consumers who cannot soreadily reduce their water use.” In what wayis the Los Angeles system for allocating waterinefficient? In what way does the systemseem unfair?

d. Suppose instead that Los Angeles allowedthe price of water to increase until the quan-tity demanded equaled the quantity sup-plied. Would the resulting allocation of waterbe more efficient? In your view, would it befairer or less fair than the proportionatereductions in water use mentioned in thenewspaper article? What could be done tomake the market solution fairer?

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11. The supply and demand for broccoli aredescribed by the following equations:

Supply: QS � 4 P � 80Demand: QD �100 � 2 P.

Q is in bushels, and P is in dollars per bushel.a. Graph the supply curve and the demand

curve. What is the equilibrium price andquantity?

158 PART 3 MARKETS AND WELFARE

b. Calculate consumer surplus, producer sur-plus, and total surplus at the equilibrium.

c. If a dictator who hated broccoli were to banthe vegetable, who would bear the largerburden—the buyers or sellers of broccoli?

For further information on topics in this chapter, additional problems, examples, applications, online quizzes, and more, please visit our website athttp://mankiw.swlearning.com.

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