CHAPTER 5

Consumers, Producers,
and the Efficiency of Markets
Microeonomics
PRINCIPLES OF

N. Gregory Mankiw

Book by Gregory Mankiw

Slides by Ronald Cronovich
 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?

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 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.

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 4.1. CONSUMERS SURPLUS

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 4.1.1. Willingness to Pay (WTP)
A buyer’s willingness to pay for a good is the
maximum amount the buyer will pay for that good.
WTP measures how much the buyer values the good.

name WTP Example:

4 buyers’ WTP
Anthony $250
for an iPod
Chad 175
Flea 300
John 125

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 4.1.2. 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

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 4.1.2. WTP and the Demand Curve

Derive the P (price

demand who buys Qd
of iPod)
schedule:
$301 & up nobody 0

name WTP 251 – 300 Flea 1

Anthony $250 176 – 250 Anthony, Flea 2

Chad 175 Chad, Anthony,
126 – 175 3
Flea 300 Flea
John, Chad,
John 125 0 – 125 4
Anthony, Flea

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 4.1.2. WTP and the Demand Curve
P
$350 P Qd
$300
$301 & up 0
$250
$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…
P This D curve looks like a staircase
$350 with 4 steps – one per buyer.
$300 If there were a huge # of buyers,
as in a competitive market,
$250
there would be a huge #
$200
of very tiny steps,
$150 and it would look
$100 more like a smooth
curve.
$50
$0 Q
0 1 2 3 4
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 WTP and the Demand Curve
P At any Q,
Flea’s WTP
$350 the height of
Anthony’s WTP the D curve is
$300
the WTP of the
$250 Chad’s WTP marginal buyer,
$200 the buyer who

$150 John’s WTP would leave the

market if P were
$100 any higher.
$50
$0 Q
0 1 2 3 4
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 4.1.3. 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.

Flea’s CS = $300 – 260 = $40.
Anthony $250
The others get no CS because
Chad 175 they do not buy an iPod at this
Flea 300 price.
John 125 Total CS = $40.

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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
P
Flea’s WTP Instead, suppose
$350
P = $220
$300 Anthony’s WTP Flea’s CS =
$250 $300 – 220 = $80
$200 Anthony’s CS =
$250 – 220 = $30
$150
Total CS = $110
$100
$50
$0 Q
0 1 2 3 4
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 CS and the Demand Curve
P
The lesson:
$350
Total CS equals
$300 the area under
$250 the demand curve
above the price,
$200 from 0 to Q.
$150
$100
$50
$0 Q
0 1 2 3 4
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 CS with Lots of Buyers & a Smooth D
Curve
Price
P The demand for shoes
per pair
$ 60
At Q = 5(thousand), 50
the marginal buyer
40
is willing to pay $50
1000s of
for pair of shoes. 30
pairs of
Suppose P = $30. 20 shoes
Then his consumer 10
surplus = $20. 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 b/w The demand for shoes
P
P and the D curve,
from 0 to Q. $ 60

Recall: area of 50
h
a triangle equals 40
½ x base x height
30
Height =
$60 – 30 = $30. 20

So, 10
D
CS = ½ x 15 x $30 0 Q
= $225. 0 5 10 15 20 25 30

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 How a Higher Price Reduces CS

If P rises to $40, P
1. Fall in CS
CS = ½ x 10 x $20 60
due to buyers
= $100. 50 leaving market
Two reasons for the 40
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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 ACTIVE LEARNING 1
Consumer surplus
demand curve
A. Find marginal P
50
buyer’s WTP at $ 45
Q = 10. 40
B. Find CS for 35
P = $30. 30
Suppose P falls to $20. 25
How much will CS 20
increase due to…
15
C. buyers entering
10
the market
5
D. existing buyers
0
paying lower price
0 5 10 15 20 Q
25
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 ACTIVE LEARNING 1
Answers
demand curve
A. At Q = 10, marginal P
50
buyer’s WTP is $30. $ 45
B. CS = ½ x 10 x $10 40
= $50 35
P falls to $20. 30
25
C. CS for the
20
additional buyers
= ½ x 10 x $10 = $50 15
10
D. Increase in CS
5
on initial 10 units
= 10 x $10 = $100 0
0 5 10 15 20 Q
25
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 4.2. PRODUCERS SURPLUS

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 4.2.1. Cost and the Supply Curve
 Cost is the value of everything a seller must give 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.
 Example: Costs of 3 sellers in the lawn-cutting
business.
name cost A seller will produce and sell
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.

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 4.2.2. Cost and the Supply Curve

Derive the supply schedule P Qs

from the cost data:
$0 – 9 0

10 – 19 1

name cost 20 – 34 2

Jack $10 35 & up 3

Janet 20
Chrissy 35

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 4.2.2. 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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 4.2.2. Cost and the Supply Curve
P
At each Q,
$40
Chrissy’s the height of
the S curve
$30 cost 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

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 4.2.3. 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

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 Producer Surplus and the S Curve
P PS = P – cost
$40 Suppose P = $25.
Chrissy’s
Jack’s PS = $15
$30 cost Janet’s PS = $5
Janet’s
$20 Chrissy’s PS = $0
cost
Total PS = $20
$10 Jack’s cost
Total
Total PS
PS equals
equals the
the
area
area above
above the
the supply
supply
$0 Q
curve
curve under
under the
the price,
price,
0 1 2 3 from
from 00 to
to Q.
Q.
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 PS with Lots of Sellers & a Smooth S
Curve
Price P The supply of shoes
per pair
60
50 S
Suppose P = $40.
40
At Q = 15(thousand),
the marginal seller’s 30
cost is $30, 1000s of pairs
20 of shoes
and her producer
10
surplus is $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 b/w P The supply of shoes
P and the S curve, 60
from 0 to Q.
50 S
The height of this
triangle is 40
$40 – 15 = $25. 30
h
So, 20
PS = ½ x b x h
10
= ½ x 25 x $25
= $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 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

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 ACTIVE LEARNING 2
Producer surplus
supply curve
A. Find marginal P
50
seller’s cost 45
at Q = 10. 40
B. Find total PS for 35
P = $20. 30
Suppose P rises to $30. 25
Find the increase 20
in PS due to… 15
C. selling 5 10
additional units 5
D. getting a higher price 0
on the initial 10 units Q
0 5 10 15 20 25
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 ACTIVE LEARNING 2
Answers
supply curve
A. At Q = 10, P
50
marginal cost = $20 45
B. PS = ½ x 10 x $20 40
= $100 35
P rises to $30. 30
25
C. PS on
20
additional units
= ½ x 5 x $10 = $25 15
10
D. Increase in PS
on initial 10 units 5
= 10 x $10 = $100 0
0 5 10 15 20 Q
25
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 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)

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 4.3. The Market’s Allocation of Resources
 In a market economy, the allocation of resources
is decentralized, determined by the interactions
of many self-interested buyers and sellers.
 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 of
society’s well-being, and we consider whether the
market’s allocation is efficient.
(Policymakers also care about equality, though are
focus here is on efficiency.)
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 4.3.1. Efficiency
Total
surplus = (value to buyers) – (cost to sellers)

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.

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 Evaluating the Market Equilibrium
P
Market eq’m:
60
P = $30
Q = 15,000 50 S
Total surplus 40 CS
= CS + PS
30
Is the market eq’m PS
20
efficient?
10
D
0 Q
0 5 10 15 20 25 30

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 Which Buyers Consume the Good?
Every buyer P
whose WTP is 60
≥ $30 will buy.
50 S
Every buyer
40
whose WTP is
< $30 will not. 30

So, the buyers 20

who value the 10
good most highly D
are the ones who 0 Q
consume it. 0 5 10 15 20 25 30

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 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
not. 30
So, the sellers with 20
the lowest cost
10
produce the good. D
0 Q
0 5 10 15 20 25 30

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 Does Eq’m Q Maximize Total Surplus?
At Q = 20, P
cost of producing
60
the marginal unit
is $35 50 S
value to consumers 40
of the marginal unit
is only $20 30
Hence, can increase 20
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

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 Does Eq’m Q Maximize Total Surplus?
At Q = 10, P
cost of producing
60
the marginal unit
is $25 50 S
value to consumers 40
of the marginal unit
is $40 30
Hence, can increase 20
total surplus
10
by increasing Q. D
This is true at any Q 0 Q
less than 15. 0 5 10 15 20 25 30

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 Does Eq’m Q Maximize Total Surplus?

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

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 4.3.1. 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.

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 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…

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