PowerPoint Lecture Notes for Chapter 7:

Consumers, Producers, and the Efficiency of Markets

Principles of Economics 5th edition, by N. Gregory Mankiw
Premium PowerPoint Slides by Ron Cronovich

This is a very theoretical chapter. Most students in principles-

CHAPTER
7
level courses are a bit less patient with theory than with real-
Consumers, Producers, world applications. However, you can tell your students that
and the Efficiency of Markets
learning the material in this chapter will pay off in (at least)
Economics
PRINCI PLES OF

N. Gregory Mankiw
two ways.

Premium PowerPoint Slides

by Ron Cronovich
First, the tools introduced in this chapter (consumer &
© 2009 South-Western, a part of Cengage Learning, all rights reserved
producer surplus, welfare economics) are used extensively in
the real world to assess the costs and benefits of policies and
market imperfections. When does a policy do more harm
than good? Who does the policy make better off, and who is
made worse off? How do the total gains to the winners
compare to the total losses incurred by the losers? The
following two chapters will use the tools of welfare
economics to analyze taxes and international trade (including
restrictions on trade). Students typically find these
applications very interesting, and they are much easier to
learn after students have a good working knowledge of the
material covered in this chapter.

Second, this chapter illuminates one of the most important

ideas in economics: Adam Smith’s invisible hand, a.k.a. the
principle that markets are usually a good way to organize
economic activity.

Note that this analysis assumes perfect competition. When

this assumption fails, the market on its own may not
maximize society’s well-being. We will study such market
failures in later chapters, and we’ll use the tools of welfare
economics to see how public policy can improve on the
market outcome in such cases.
In this chapter,
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?

Welfare Economics
§ Recall, the 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.
§ First, we look at the well-being of consumers.

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 5

Willingness to Pay (WTP) FYI: The four guys in this example are the members of the
A buyer’s willingness to pay for a good is the Red Hot Chili Peppers. In the corresponding example from
maximum amount the buyer will pay for that good.
WTP measures how much the buyer values the good. the textbook, Mankiw uses the Beatles.
name WTP Example:
4 buyers’ WTP
Anthony $250
for an iPod
Chad 175
Flea 300
John 125

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 6

WTP and the Demand Curve

Q: If price of iPod is $200, who will buy an iPod, and
what is quantity demanded?

A: Anthony & Flea will buy an iPod,

Chad & John will not.
name WTP
Hence, Qd = 2
Anthony $250 when P = $200.
Chad 175
Flea 300
John 125

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 7

 WTP and the Demand Curve Give your students a few moments to fill in the table. Then
Derive the
P (price
reveal the answers. Tell them that they have just constructed
demand who buys Qd
schedule:
of iPod)
the demand schedule for iPods.
$301 & up nobody 0

name WTP 251 – 300 Flea 1

Anthony $250 176 – 250 Anthony, Flea 2 Next, we will use the demand schedule to draw the demand
Chad 175 Chad, Anthony,
Flea 300
126 – 175
Flea
3 curve (just like in Chapter 4 when we first covered demand
John, Chad,
John 125 0 – 125
Anthony, Flea
4 schedules & curves).
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 8

WTP and the Demand Curve The table on this slide consists of the 1st and 3rd columns of
P
$350
the table on the preceding slide. The numbers in these
P Qd
$300 columns are the demand schedule for iPods, and give us the
$250 $301 & up 0

$200 251 – 300 1

demand curve shown in the graph on this slide.
$150 176 – 250 2
$100
126 – 175 3
$50 The animation is as follows:
0 – 125 4
$0 Q
0 1 2 3 4
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 9
When P is $301 or higher, Qd is zero. That part of the table is
highlighted when the upper-most segment of the demand
curve is revealed.

If the price falls to $300, then Qd increases to 1.

If the price is anywhere in the range $251-300, Qd = 1.

If the price falls to $250, then Qd increases to 2.

If the price is anywhere in the range $176-250, Qd = 2.

…and so forth.
 About the Staircase Shape… After the previous slide, most of your students will probably
P
$350
This D curve looks like a staircase
with 4 steps – one per buyer.
understand where this D curve comes from, but its staircase-
$300 If there were a huge # of buyers,
as in a competitive market,
like shape will seem quite odd to them.
$250
there would be a huge #
$200
of very tiny steps,
$150 and it would look Point out that it has 4 “steps,” one for each buyer. Suppose
$100 more like a smooth
$50
curve. there were 10 buyers instead of 4; how many steps would it
$0
0 1 2 3 4
Q
have? Ten, of course. If there were 20 buyers, this D “curve”
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 10
would have 20 steps.

A perfectly competitive market has a huge number of buyers.

Suppose there were 10,000 buyers in the market for iPods (a
tiny fraction of the actual number of buyers!). Then, the
number of steps would be 10,000. In relation to the graph,
each step would be insignificantly small, and the D curve
would look like a smooth curve rather than a staircase – even
though it really is a staircase – one with 10,000 infinitesimally
small steps.

WTP and the Demand Curve When Q = 1, the height of the demand curve is $300, which is
P
$350
Flea’s WTP At any Q, Flea’s willingness to pay, or how much he values an iPod. At
the height of
$300 Anthony’s WTP the D curve is
the WTP of the
any price higher than $300, Flea leaves the market; hence, at
$250 Chad’s WTP
$200
John’s
marginal buyer,
the buyer who
Q = 1, Flea is the marginal buyer.
WTP
$150 would leave the
market if P were
$100 any higher.
$50 When Q = 2, the height of the demand curve is $250, which is
$0
0 1 2 3 4
Q
Anthony’s willingness to pay, or how much he values an
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 11
iPod. At any price higher than $250, Anthony leaves the
market; hence, at Q = 2, Anthony is the marginal buyer.

And so forth.

The lesson here is summarized in the text on the right side of

the screen: At each Q, the height of the D curve tells you the
marginal buyer’s willingness to pay, or how much that buyer
values the good.
 Consumer Surplus (CS)
Consumer surplus is the amount a buyer is willing
to pay minus the amount the buyer actually pays:
CS = WTP – P

name WTP Suppose P = $260.

Anthony $250 Flea’s CS = $300 – 260 = $40.

The others get no CS because
Chad 175
they do not buy an iPod at this
Flea 300 price.
John 125 Total CS = $40.

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 12

CS and the Demand Curve The area of any rectangle equals base times height.
P
Flea’s WTP P = $260
$350
Flea’s CS =
$300 $300 – 260 = $40 For the green rectangle on this slide,
$250 Total CS = $40
$200 base = 1
$150 height = $300 – 260 = $40
$100
$50 area = 1 x $40 = $40
$0 Q
0 1 2 3 4
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 13

CS and the Demand Curve The entire green area (total CS) can be divided into two
P
$350
Flea’s WTP Instead, suppose rectangles:
P = $220
$300 Anthony’s WTP
Flea’s CS =
$250 $300 – 220 = $80
$200 Anthony’s CS = The first (and leftmost) represents Flea’s CS. It has a height
$250 – 220 = $30
$150
Total CS = $110 of $80 and a width of 1.
$100
$50
$0
0 1 2 3 4
Q The second represents Anthony’s CS. It has a height of $30
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 14
and a width of 1.

The sum of these two rectangular areas equals total CS.

CS and the Demand Curve The text in the yellow box summarizes the lesson of the two
P
$350 The lesson: preceding slides.
$300 Total CS equals
the area under
$250 the demand curve
$200 above the price,
from 0 to Q.
$150
$100
$50
$0 Q
0 1 2 3 4
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 15
CS with Lots of Buyers & a Smooth D Curve In “normal” or edit mode, the text appears to overlap with the
At Q = 5(thousand),
Price P The demand for shoes vertical axis label. Don’t worry – in “Slide Show” or
the marginal buyer
per pair
$ 60
is willing to pay $50
for pair of shoes. 50
presentation mode, the axis labels disappear before the text
Suppose P = $30. 40 appears.
Then his consumer 30
surplus = $20. 1000s of pairs
20 of shoes
10
D
0 Q
0 5 10 15 20 25 30
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 16

CS with Lots of Buyers & a Smooth D Curve Some students mistake the upper vertical intercept ($60 in this
CS is the area b/w
P and the D curve,
P The demand for shoes example) for the height of the blue triangle: they forget to
$ 60
from 0 to Q.
50
subtract off the height of the bottom of the triangle from the
Recall: area of
h
a triangle equals
½ x base x height
40 height of the top of the triangle. So, the first one or two
30
Height =
20
times, it might be worthwhile to show them how to find the
$60 – 30 = $30.
So,
10
D
height of the triangle.
CS = ½ x 15 x $30 0 Q
= $225. 0 5 10 15 20 25 30
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 17

How a Higher Price Reduces CS The book shows how a lower price increases CS.
If P rises to $40,
P
CS = ½ x 10 x $20 1. Fall in CS
60
= $100. due to buyers
50 leaving market
Two reasons for the
fall in CS. 40
30

2. Fall in CS due to 20
remaining buyers 10
paying higher P D
0 Q
0 5 10 15 20 25 30
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 18

ACTIVE LEARNING 1
Consumer surplus
surplus demand curve
P
50
A. Find marginal $ 45
buyer’s WTP at 40
Q = 10.
35
B. Find CS for 30
P = $30.
25
Suppose P falls to $20.
20
How much will CS
increase due to… 15
10
C. buyers entering
the market 5
D. existing buyers
0
paying lower price 0 5 10 15 20 Q
25
19
 ACTIVE LEARNING 1
Answers demand curve
P
50
A. At Q = 10, marginal $ 45
buyer’s WTP is $30. 40
B. CS = ½ x 10 x $10 35
= $50 30
P falls to $20. 25
20
C. CS for the
15
additional buyers
= ½ x 10 x $10 = $50 10
5
D. Increase in CS
0
on initial 10 units
= 10 x $10 = $100 0 5 10 15 20 Q
25
20

Cost and the Supply Curve The material on cost, producer surplus, and the supply curve
§ Cost is the value of everything a seller must give is analogous to the material earlier on WTP, consumer
up to produce a good (i.e., opportunity cost).
§ Includes cost of all resources used to produce
good, including value of the seller’s time.
surplus, and the demand curve. Therefore, this section
§ Example: Costs of 3 sellers in the lawn-cutting provides a bit less detail and should move a little more
business.
name cost A seller will produce and sell quickly.
the good/service only if the
Jack $10 price exceeds his or her cost.
Janet 20
Hence, cost is a measure of
Chrissy 35 willingness to sell.
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 21

Cost and the Supply Curve Your students should be able to figure out how to get the Qs
numbers in the second column of the table.
P Qs
Derive the supply 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
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 22

Cost and the Supply Curve The derivation of the staircase-supply curve is analogous to
P that of the staircase demand curve in the earlier example.
$40 P Qs

$0 – 9 0
Hence, the animation is not as detailed.
$30
10 – 19 1
$20
20 – 34 2

$10 35 & up 3

$0 Q
0 1 2 3
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 23
 Cost and the Supply Curve For your students’ future reference, you might also note that
P
At each Q,
we can use the term “marginal cost” as short-hand for “cost of
$40 the height of
Chrissy’s
cost the S curve the marginal seller.”
$30 is the cost of the
Janet’s marginal seller,
$20 cost the seller who
would leave
$10 Jack’s cost the market if
the price were
$0 Q any lower.
0 1 2 3
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 24

Producer Surplus
P PS = P – cost
$40 Producer surplus (PS):
the amount a seller
$30 is paid for a good
minus the seller’s cost
$20

$10

$0 Q
0 1 2 3
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 25

Producer Surplus and the S Curve

P PS = P – cost
$40 Suppose P = $25.
Chrissy’s
cost Jack’s PS = $15
$30
Janet’s Janet’s PS = $5
$20 cost Chrissy’s PS = $0

$10 Jack’s cost Total PS = $20

Total
Total PSPS equals
equals thethe
$0 Q area above the supply
area above the supply
0 1 2 3 curve
curve under
under the
the price,
price,
from to Q.
from 00 to Q.
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 26

PS with Lots of Sellers & a Smooth S Curve

Suppose P = $40.
Price P The supply of shoes
per pair
At Q = 15(thousand), 60
the marginal seller’s S
50
cost is $30,
40
and her producer
surplus is $10. 30
1000s of pairs
20 of shoes
10
0 Q
0 5 10 15 20 25 30
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 27
PS with Lots of Sellers & a Smooth S Curve
PS is the area b/w P The supply of shoes
P and the S curve,
from 0 to Q. 60
50 S
The height of this
triangle is 40
$40 – 15 = $25.
30
So, h
20
PS = ½ x b x h
= ½ x 25 x $25 10
= $312.50 0 Q
0 5 10 15 20 25 30
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 28

How a Lower Price Reduces PS

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

2. Fall in PS due to 20
remaining sellers 10
getting lower P
0 Q
0 5 10 15 20 25 30
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 29

ACTIVE LEARNING 2
Producer surplus supply curve
50 P
A. Find marginal
45
seller’s cost
at Q = 10. 40
35
B. Find total PS for
P = $20. 30
25
Suppose P rises to $30.
20
Find the increase
in PS due to… 15
C. selling 5 10
additional units 5
D. getting a higher price 0
on the initial 10 units 0 5 10 15 20 Q
25
30

ACTIVE LEARNING 2
Answers supply curve
50
P
A. At Q = 10, 45
marginal cost = $20
40
B. PS = ½ x 10 x $20 35
= $100 30
P rises to $30. 25
C. PS on 20
additional units 15
= ½ x 5 x $10 = $25 10
D. Increase in PS 5
on initial 10 units 0
= 10 x $10 = $100 0 5 10 15 20 Q
25
31
 CS, PS, and Total Surplus
CS = (value to buyers) – (amount paid by buyers)
= buyers’ gains from participating in the market
PS = (amount received by sellers) – (cost to sellers)
= sellers’ gains from participating in the market
Total surplus = CS + PS
= total gains from trade in a market
= (value to buyers) – (cost to sellers)
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
It might help to say “participating in the market” means
buying and selling.
It might also help to say that CS measures the net benefit to
buyers: the value they get from the good is the gross benefit,
minus what they pay leaves the net benefit, or CS. Similarly,
PS is the net benefit to sellers. I did not put “net benefit” on
32
this slide because it is not in the book. But if you wish, you
may add it.
After showing this slide in class, I show my students a short
scene from the movie “Pretty Woman” as an example of these
concepts. In this scene, Julia Roberts is taking a bubble bath
in Richard Gere’s hotel room (don’t worry – there’s no
nudity!). Gere comes into the bathroom and they negotiate a
price for her to “be at his beck and call” for one week. After
bargaining for a few seconds, they agree on a price of $3000.
A minute later, he says he would have paid $4000 (his
willingness to pay), and she says she would have accepted
$2000 (her “cost”). From this, we can deduce that CS =
$1000, PS = $1000, and total surplus = $2000. If this
transaction did not occur, then these characters would not
have received these “gains from trade.”
Disclaimer: We officially urge you to consult with your
institution’s legal advisor to verify that showing this brief clip
in your class does not violate any copyright laws. We accept
no responsibility in this matter. For example, we absolutely
do not recommend that you rent “Pretty Woman” on DVD,
download a free evaluation copy of a program like AoA DVD
Ripper from the website www.aoamedia.com, and use that
software to create a video clip of the above-described segment
of Pretty Woman from the DVD, a video clip which could
then be moved to the computer in your classroom to be shown
in your classroom presentation of this chapter. We urge you
to respect the intellectual property of others, and all copyright
laws.
The Market’s Allocation of Resources Is the market’s allocation of resources desirable? This
§ In a market economy, the allocation of resources question is important, because the answer to it has
is decentralized, determined by the interactions
of many self-interested buyers and sellers. implications for the proper role and scope of government.
§ Is the market’s allocation of resources desirable?
Or would a different allocation of resources make
society better off?
§ To answer this, we use total surplus as a measure
If the market’s allocation is generally desirable, then the role
of society’s well-being, and we consider whether
the market’s allocation is efficient. of government should be limited to the protection of property
(Policymakers also care about equality, though are
focus here is on efficiency.)
rights, national defense and so forth. If not, then public
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 33
policy may potentially be able to improve upon the market’s
allocation.

Efficiency
Total
= (value to buyers) – (cost to sellers)
surplus

An allocation of resources is efficient if it maximizes

total surplus. Efficiency means:
§ The goods are consumed by the buyers who
value them most highly.
§ The goods are produced by the producers with the
lowest costs.
§ Raising or lowering the quantity of a good
would not increase total surplus.

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 34

Evaluating the Market Equilibrium

Market eq’m: P
P = $30
60
Q = 15,000
50 S
Total surplus
= CS + PS 40 CS
Is the market eq’m 30
PS
efficient? 20
10
D
0 Q
0 5 10 15 20 25 30
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 35

Which Buyers Consume the Good? It may be worth reminding your students that, at each Q, the
Every buyer P height of the D curve is the marginal buyer’s valuation of the
whose WTP is
60
≥ $30 will buy.
50 S
good. Hence, the buyers from 0 to 15 all value the good at
Every buyer
whose WTP is 40 least as much as the price, so they will purchase the good at
< $30 will not. 30
So, the buyers 20
the market price.
who value the
10
good most highly D
are the ones who 0 Q
consume it. 0 5 10 15 20 25 30 The buyers from 15 on up value the good less than $30, so
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 36
they won’t buy the good.
 Which Sellers Produce the Good? Because the height of the S curve tells us seller’s costs, we
Every seller whose
cost is ≤ $30 will
P can determine the following:
60
produce the good.
50 S
Every seller whose
cost is > $30 will 40 The sellers of the first 15 units have cost < $30, so it is
not. 30
So, the sellers with 20
worthwhile for them to produce the good.
the lowest cost
produce the good. 10
D
0 Q
0 5 10 15 20 25 30 The other sellers have cost > $30, so they will not sell the
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 37
good if P = $30.

Does Eq’m Q Maximize Total Surplus? This slide shows that, if we are starting from a Q greater than
At Q = 20,
cost of producing
P the market equilibrium quantity, we can increase total surplus
60
the marginal unit
is $35 50 S
by reducing Q. The slide demonstrates this for one particular
value to consumers
of the marginal unit
40 Q (20), but it is true for any Q greater than the equilibrium
is only $20 30
Hence, can increase 20
quantity.
total surplus
10
by reducing Q. D
This is true at any Q 0 Q
greater than 15. 0 5 10 15 20 25 30 Thus, if we continue to reduce Q, total surplus will continue
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 38
to increase – until we get to the equilibrium quantity.

Does Eq’m Q Maximize Total Surplus? This slide shows that, if we are starting from a Q less than the
At Q = 10,
cost of producing
P market equilibrium quantity, we can increase total surplus by
60
the marginal unit
is $25 50 S
increasing Q. The slide demonstrates this for one particular Q
value to consumers
of the marginal unit
40 (10), but it is true for any Q below the equilibrium quantity.
is $40 30
Hence, can increase 20
total surplus
by increasing Q.
10
D
Thus, if we continue to increase Q, total surplus will continue
This is true at any Q 0 Q
less than 15. 0 5 10 15 20 25 30 to increase – until we get to the equilibrium quantity.
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 39

Does Eq’m Q Maximize Total Surplus? This slide summarizes the lesson of the preceding two slides.
The market P
eq’m quantity 60
maximizes 50 S
total surplus:
At any other 40
quantity, 30
can increase
20
total surplus by
moving toward 10
D
the market eq’m 0 Q
quantity. 0 5 10 15 20 25 30
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 40
 Adam Smith and the Invisible Hand This and the following slide contain passages from The
Passages from The Wealth of Nations, 1776
“Man has almost constant occasion
Wealth of Nations. It would be hard to overstate the impact of
for the help of his brethren, and it is
vain for him to expect it from their the ideas in these passages.
benevolence only. He will be more
likely to prevail if he can interest their
self-love in his favor, and show them
that it is for their own advantage to do I have included them here because students should be able to
for him what he requires of them…
It is not from the benevolence of the
butcher, the brewer, or the baker that
better understand and appreciate their significance after
Adam Smith,
we expect our dinner, but from their
1723-1790
regard to their own interest…. having just seen the analysis of market efficiency.
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 41

If you’re pressed for time, you might delete the first of these
two slides, as it is probably less important than the second
one. The passages on this first slide convey the sense that the
economy is made up of a completely uncoordinated mass of
individuals, each acting in his or her own self interest. On the
next slide, Smith discusses the invisible hand.

Adam Smith and the Invisible Hand

Passages from The Wealth of Nations, 1776
“Every individual…neither intends to
promote the public interest, nor knows
how much he is promoting it….
He intends only his own gain, and he is
in this, as in many other cases, led by
an invisible hand to promote an end
which was no part of his intention.
Nor is it always the worse for the society
that it was no part of it. By pursuing his
own interest he frequently promotes
Adam Smith,
that of the society more effectually than
1723-1790
when he really intends to promote it.”
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 42

The Free Market vs. Govt Intervention

§ The market equilibrium is efficient. No other
outcome achieves higher total surplus.
§ Govt cannot raise total surplus by changing the
market’s allocation of resources.
§ Laissez faire (French for “allow them to do”):
the notion that govt should not interfere with the
market.

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 43

The free market vs. central planning Example of central planner: the Communist leaders of the
§ Suppose resources were allocated not by the former Soviet Union.
market, but by a central planner who cares about
society’s well-being.
§ To allocate resources efficiently and maximize total
surplus, the planner would need to know every
seller’s cost and every buyer’s WTP for every good
in the entire economy.
§ This is impossible, and why centrally-planned
economies are never very efficient.

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 44

 CONCLUSION
§ This chapter used welfare economics to
demonstrate one of the Ten Principles:
Markets are usually a good way to
organize economic activity.
§ Important note:
We derived these lessons assuming
perfectly competitive markets.
§ In other conditions we will study in later chapters,
the market may fail to allocate resources
efficiently…

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 45

CONCLUSION The italicized terms market power and externalities will be

§ Such market failures occur when: formally defined in later chapters.
§ a buyer or seller has market power – the ability to
affect the market price.
§ transactions have side effects, called externalities,
that affect bystanders. (example: pollution)
§ We’ll use welfare economics to see how public policy
may improve on the market outcome in such cases.
§ Despite the possibility of market failure, the analysis
in this chapter applies in many markets, and the
invisible hand remains extremely important.

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 46

CHAPTER SUMMARY

§ The height of the D curve reflects the value of the

good to buyers—their willingness to pay for it.
§ Consumer surplus is the difference between what
buyers are willing to pay for a good and what they
actually pay.
§ On the graph, consumer surplus is the area
between P and the D curve.

47

CHAPTER SUMMARY

§ The height of the S curve is sellers’ cost of

producing the good. Sellers are willing to sell if the
price they get is at least as high as their cost.
§ Producer surplus is the difference between what
sellers receive for a good and their cost of
producing it.
§ On the graph, producer surplus is the area
between P and the S curve.

48

CHAPTER SUMMARY

§ To measure of society’s well-being, we use

total surplus, the sum of consumer and producer
surplus.
§ Efficiency means that total surplus is maximized,
that the goods are produced by sellers with lowest
cost, and that they are consumed by buyers who
most value them.
§ Under perfect competition, the market outcome is
efficient. Altering it would reduce total surplus.
49