İktisada Giriş Markets and Welfare Week 4: Markets and Welfare In this part, we will analyze whether the free c ompetitive markets are efficient or not. We will do this by testing whether free, competitive market outcome achieves the largest possible welfare for the society. If free competi tive markets achieve the largest welfare, then they must be efficient. 4.1 Demand and Marginal Benefit A consumer ’ s demand curve shows her marginal benefit (MB) for every unit of a good. Marginal benefit is the benefit (utility, enjoyment) from the last u nit of the good consumed . It is the value of enjoyment that an individual receives from consuming the last unit of that good. Consider Mary ’ s demand for cookies. Price Mary ’ s Demand 2.5 0 2 1 1.5 2 1 3 0.5 4 TABLE 13 Mary ’ s Demand for Cookies 10.5 1.5 2.0 1.0 5 2 1 3 4 2.5 3.0 quantity demanded (cookies per day) price (liras/cookie) marginal benefit D=MB FIGURE 14 Mary ’ s Demand for Cookies Mary ’ s MB from eating the first cookie is 2 liras. Her MB from eating the 4 th cookie is only 0.5 liras. Height of the demand curve tells us the amount of marginal benefit that the consumer receives from consuming that one unit. Economists argue that a consumer ’ s marginal benefit (MB) always decreases as she consumes more of the same good. Think of yourself. When you are thirsty, you would highly appreciate a cup of water. The value of the first cup i s very high. Then you might also like to drink a second cup. But you may not want to drink the third cup. You would definitely not want to drink the fourth cup. The MB of the first cup is greater than the second cup. MB of the fourth cup is zero for you. T his is called diminishing MB . Individual and Market Demand Consider Mary and David ’ s demand for cookies. Let us assume that only Mary and David buy cookies in this simple economy. Market demand is the horizontal sum of 2individual demand curves and is calc ulated by adding the quantities demanded by all individuals at each price. Price Mary ’ s Demand David ’ s Demand Market Demand 2.5 0 0 0 2 1 0 1 1.5 2 0 2 1 3 1 4 0.5 4 2 6 0.5 1.5 2.0 1.0 5 2 1 3 4 2.5 3.0 quantity demanded (cookies per day) price (liras/cookie) D=MB Figure 1 5 : David ’ s demand for cookies 30.5 1.5 2.0 1.0 5 2 1 3 4 2.5 3.0 quantity demanded (cookies per day) price (liras/cookie) 6 D=MB FIGURE 1 6 : Market demand for cookies We know that the individual ’ s demand curves show the MB of that individual from consuming each unit. Then the market demand curve shows the MB of the society from consuming each unit of that good. Becaus e society is the collection of its individuals. For example, the MB of the society from consuming the 4 th cookie is 1 lira. This comes from two sources. Mary ’ s MB from the 3 rd cookie is 1 lira. Also, David ’ s MB from 1 st cookie is 1 lira. Since there are on ly two people in this economy, the society ’ s MB from 3+1 = 4 th cookie becomes 1 lira. Society is willing to pay 1 lira for the 4 th cookie. 4.3 Consumer Surplus Let us go back to Mary ’ s cookie demand. Let us assume that the market price of cookies is 1 lira . Then, from the first cookie, Mary gets MB of 2 liras. But she pays only 1 lira price to buy the cookie. So she enjoys 1 lira extra benefit from the first cookie. We call this extra benefit consumer surplus . Consumer surplus is the 4marginal benefit of th e good minus the price paid for it, summed over all units consumed. 0.5 1.5 2.0 1.0 5 2 1 3 4 2.5 3.0 quantity demanded (cookies per day) price (liras/cookie) market price consumer surplus D=MB FIGURE 1 7: Consumer Surplus Mary ’ s consumer surplus (CS) from the first cookie is 1 lira. If we sum up the CS from ALL the units consumed, CS is the area abov e the market price and below the demand curve. This is the area of the triangle given by ( 3 x 1.5 ) / 2 = 2.25. David ’ s CS is shown on Figure 18. His CS is equal to ( 1 x 0.5 ) / 2 = 0.25. 5 0.5 1.5 2.0 1.0 5 2 1 3 4 2.5 3.0 quantity demanded (cookies per day) price (liras/cookie) market price D=MB FIGURE 18: David ’ s CS Society ’ s CS is the sum of all individual ’ s CS ’ es. So, society ’ s CS is 2.25 + 0.25 = 2.5. We can also calculate the society ’ s CS from the market demand curve. CS is the area below the demand curve and above the market price. Try to find this area on Fi gure 16 and verify that it is equal to 2.5. 0.5 1.5 2.0 1.0 5 2 1 3 4 2.5 3.0 quantity demanded (cookies per day) price (liras/cookie) 6 market price D=MB FIGURE 19: Society ’ s CS 6For a general demand curve where there are many many individuals, such as the one on Figure 20, CS is the area above the market price and below the demand cur ve. P Q D=MB CS market price FIGURE 20: A General demand curve 4.4 Supply and Marginal Cost Each producer ’ s objective is to maximize her profit. Profit is the difference between revenue from selling the product and cost of production. So she must sell h er good at a price above the cost of producing that good. If the price is too small, she would not produce it. The cost of producing the last unit of a good is called marginal cost . The height of a producer ’ s supply curve shows the marginal cost (MC) of producing a particular unit of a good. For example, consider the supply of cookies. Remzi ’ s supply curve for cookies is given on Figure 21. 70.5 1.5 2.0 1.0 5 2 1 3 4 2.5 3.0 quantity demanded (cookies per day) price (liras/cookie) marginal cost S=MC FIGURE 21: Remzi ’ s supply of cookies For Remzi, baking the first cookie costs 1 lira. Baking the 2 nd cookie costs 1.5 lira. Marginal cost of the 4 th cookie is 2.5 lira. Economists assume that as the number of cookies increases, MC increases. This is because as the economy produces more cookies, opportunity cost of one cookie in terms of ot her goods as well as in terms of liras increases. This is the same idea that we explained during the PPF model at the beginning of the semester. 4.5 Producer Surplus Assume that the eqbm price of a cookie is 2 liras. Then Remzi receives 2 liras for sellin g each cookie. For the 1 st cookie, his MC is 1 lira. Then he makes a surplus of 1 lira from the first cookie. From each cookie, he makes a surplus equal to the price minus MC of baking that particular cookie. This surplus summed over all cookies sold is ca lled producer surplus . PS is the area below the market price and above the supply (=MC) curve. 80.5 1.5 2.0 1.0 5 2 1 3 4 2.5 3.0 quantity demanded (cookies per day) price (liras/cookie) marginal cost S=MC market price FIGURE 22: Remzi ’ s PS If there are more individuals in the society than Remzi, we can add their quantities supplied at each price a s we did in the demand case and we get the market supply curve. Then we find the PS as the area above the supply (=MC) and below the eqbm price. Is the Free & Competitive Market Efficient? 4.6 After introducing the concepts of CS and PS, we are ready to show t hat free & competitive markets maximize the welfare of the society. We measure the welfare of the society by the sum of CS and PS: Welfare = Total Surplus = CS + PS. Also, Total Surplus = MB – MC. 9P Q D=MB MB eqbm price S=MC eqbm qty MC Q1 MB MC Q2 FIGURE 23: Market Equilibrium Consider the free market equilibrium in Figure 23. At the equilibrium point, Total Surplus (TS) is the area below the demand curve and above the supply curve. We claim that TS is maximized at the eqbm point because at that point the MB of consuming the l ast unit of the good is equal to the MC of producing the same unit for the society. To illustrate this claim, let us start by assuming that the society produces and consumes a quantity less than the eqbm qty such as Q1 . At Q1, the MB of consuming the last unit to the society is larger than the MC of producing the same unit. This means that there is an opportunity to increase TS if the economy produces and consumes one more unit of the good. This opportunity continues until MB becomes equal to MC at the eqb m qty. Now, let us start with a qty more than the eqbm qty, such as Q2 . At Q2, MC of making the last unit to the society is larger than the marginal benefit of consuming that unit to the society. This means that we can increase TS by producing one unit 10les s because TS = MB – MC is negative at Q2. So we need to decrease output until MB = MC. This is where TS is maximized. So we have shown that the free & competitive market eqbm point indeed maximizes the TS and welfare of the society. 11