hello everyone in this lecture i will talk about consumer producer surplus and efficiency in the market in the last lecture we talked about uh elasticity and now i want to go back to the supply and demand curve and talk about the gains from interactions of consumers and producers in the market let me quote a sentence from adam smith it says that it is not from the benevolence of a butcher the brewer or baker that we expect our dinner but from their regard to their own interest in fact he means that because a butcher and a brewer can gain from interaction in the market is why they offer the products in the market in fact he believed that the market allocate goods the production and sales of the product [Music] somehow that everybody's benefit the most from the interaction in the market market reallocate the goods between the suppliers and demanders like an invisible hand such that everybody's will be better off in this lecture i will talk about the fact that markets are efficient if you have a competitive market i will talk uh in more details what is a competitive market but at the end we want to see that in such a market with some simplifying assumption we can conclude that markets are efficient what does efficiency mean it means that the butcher brewer and baker will be better off by interacting in the market and those who purchase the products from these guys will be also better off at the end the surplus the amount of benefit for consumer and producers are maximized in a market that works properly so let's start from the demand side and consumer surplus uh so suppose this is the value of a book for these guys these guys do not have a book and they want to purchase a book so they are on the demand side of the market let's uh plot our famous demand uh demand curve that's a decreasing demand curve um using these values for the product so if price is more than 60 this is if it is 70 nobody will purchase the purchase the book but if it is 60 ayesha will purchase the book so we have only one consumer so we will have only one person who wants to purchase the book now we go to price of 40 45 if price is larger than 45 again we only have aisha who purchased the book purchases the book at price of 45 we have two persons who want to purchase the book at price of two ayesha and john will purchase the book as price of 41. if price is 35 then these three guys will purchase the book so if price is 35 only 3 percent will buy the book so q is 3 if price is 25 we will have two percent uh we'll have four percent so these four guys will uh purchase the book at price of 25 and at price of 10 everybody will buy the book and if price is so this is 4 this is and if price is below 10 we'll have uh these five guys who want to buy them so this is similar to a demand curve in fact in a competitive market i will talk in more details what is the competitive market competitive market is a market where we have a lot of demand and a lot of the suppliers so you you won't see this you won't see this discrete shape in demand in a competitive market you will have a more continuous type of demand and supply so but now first consider this uh simple discrete demand curve um if price is supposed price is this much price is 50 dollars how many uh book uh how how many people will purchase the book only one person only ayesha because her uh value of the book is 60 dollars but the price in the market is 50 so it is uh price is lower than the amount that she values the book so she will purchase the book but how much is her benefit she values the book 60 dollars but she has to pay 50 dollars to purchase the book so she will benefit ten dollars if the price is fifty dollars if the price in the market is fifty dollars this is called surplus for ayesha so this is how much she benefits from purchasing the book let's try another price suppose price is 30 who will purchase the book so at price of 30 these three guys will purchase the book because their value for the book is larger than 30 dollars so we will have three person who want to buy the book again what is the surplus of each of them so for the for aisha surplus is 60 minus 30. equals 30 dollars for john it is 45 minus 30 equals 15 dollars for ellie it is five dollars so um so we can calculate total surplus total surplus will be 30 plus 15 plus five that is total benefit of those who purchase the book these guys didn't purchase the work so they they won't receive any surplus or any cost by purchasing them so total surplus will be just the sum of these surpluses or you can also see that that is this area so this is five this is 15 and this is 30 so what was consumer surplus consumer surplus was the benefit of consumers minus their cost so or let's see what is the consumer surplus of each person it is the marginal benefit minus marginal cost what do you call it marginal because that's the benefit of one person and cost of one percent so that is called marginal cost of the purchasing the book is the price but that is for only one person so this is called marginal cost so this is the consumer surplus for each person total consumer surplus is simply sum of surpluses let's try the producer surplus similar to consumer surplus producer surplus is the benefit of producers minus their cost so suppose uh these are the guys who want to sell their book these are those who have ebook if price is five dollars if price is below five dollars none of them want to sell their books so if price is below five dollars that may have it blue color here as well five dollars if price is more than five the price is five dollars then fatima will purchase the book so q is one so only one person will sell uh it's if price is larger than five dollars so fatima will sell her book until price is 15. at price of 15 now we have two sellers in the market so both allen and fatima will sell their books um until price is 25 if price is 25 we'll have three sellers in the market so this is three and these three guys will sell their books if price is 35 more than 35 fan will also sell his book so at this price we will have four sellers if price is above 45 we'll have um five sellers and if that's above 45 will have five sellers so this is similar to a supply curve now let's check the producer surplus so suppose prices yeah we better suppose price is twenty dollars who will sell their book only the first two will sell their books if price is 20 because the price is larger than how much they value the book how much they value the book is their opportunity cost of selling their book and because we are talking about each unit this is the marginal oops i don't know what i did okay um so um because we are talking about uh only one person this is also marginal cost of providing the good uh in the market so if price is 20 the surplus of fatima so she can receive 20 dollars but the value of book for her is five dollars so producer surplus of the first one for fatima is 20 minus five dollars equals to fifteen dollars what about the second what about alan his producer surplus is 20 that is the benefit of selling his book minus the cost of selling the book the opportunity cost of selling the book it is five dollars total surplus is this 15 plus five or this area this will be producer surplus if price is 20. you can calculate the same for different prices um i'm not going to repeat it again so producer surplus similar to consumer surplus is benefit minus total cost over here it is price minus marginal cost in the case of demand consumer surplus was marginal benefit benefit was the because the demand curve is marginal willingness to pay so consumer surplus equals to marginal willingness to pay minus what is the cost that is the price um and producer surplus is price minus marginal cost of selling their book or producing what is the total surplus total surplus is simply sum of consumer surplus or produ plus produce a surplus or in a more simple way it is total benefit minus cost uh for each transaction um or the benefit is the marginal willingness to pay minus marginal cost so total surplus is for each transaction marginal willingness to pay minus marginal cost that is how much people benefit from selling the book and this is how much it costs to sell the book now i can add the p and subtract a p from total surplus and you see that this part is consumer surplus and this part is produce a surplus and total surplus will be the sum of these surpluses this is the surplus for each transaction and total surplus will be some of these surpluses now let's look at the uh our example from here so this is let me erase this now this is our supply curve i want to graph the demand curve again so from here we had 60 45 35 so let me plot the demand curve it was 60 60 was 1 45 was 2. the other one was 35 25 25 10 this is our demand curve so you see that supply and demand curve interact each other here with these prices so consider suppose this is the equilibrium price that is where supply and demand equal to each other suppose 30 is the uh where supply and demand interact each other any of these prices can be the equilibrium price um at price of 30 how many suppliers do we have one two three suppliers who are the suppliers at price of 30 so fatima allen omar are willing to pay willing to sell their books so we have three suppliers how many barriers do we have at price of 30 we have one two three who will purchase the book at price of 30 so marginal willingness to pay for the book for ayusha john and ellie are larger than 30 so these guys will purchase the vote so we have three four years um what is total surplus so total surplus was the benefit minus cost for each transaction it was marginal willingness to pay minus marginal cost so the first person who sell its book is fatima if the first person who purchased the book is ayesha so how much surplus do we have asia is willing to purchase the book for sixty dollars for sixty dollars and the marginal cost of selling the book is five dollars so 60 minus five will be the surplus for the first transaction what about second transaction we are here so the second person is willing to purchase the book for 45 but the opportunity cost for allen to sell his book is 15 so the surplus will be simply 45 minus 15. what about the third person the third person is willing to purchase the book for 35 dollars the willingness to pay is 35 minus how much is the cost of selling double is 25 these are surpluses for each unit of transactions and total surplus will be some of these uh surpluses or you can check that this area will be the area of total surplus let me raise it yes this is the total surplus and it is simply the sum of consumer surplus and produces a plus how let's check it again here so this 60 minus 5 equals to 60 minus 30 plus 30 minus 5. you see that this is the consumer surplus why is this consumer surplus that is the willingness to pay for the book minus the cost of the book minus the price of the book and this is the producer surplus for the first unit that is the price minus the uh opportunity cost of selling the book and you can write the same for these two so sum of consumer and producer surplus will be the surplus from the first transaction total surplus will be some of these surpluses um let's see now let's talk about efficiency what does efficiency mean or this relates to what adam smith believes that markets are efficient efficiency means that total surplus is maximum when the market is efficient in another word who values the item the most can get the item at the end if we allow the market to be efficient and work so the market that those who value the item get the item is an efficient item the efficient market let's see if market is efficient in our example we're here so price is 30. now let's see who will have the item at the end if price is 30 fatima will sell her book so she won't have their allen will also sell uh his book he won't have the book at the end omer will also sell his book and he won't have the book at the end but femme and anya will keep their books let's check on the demand side let's see who will yeah who can purchase the book aisha is willing to pay 60 dollars for the textbook so she will have a book at the end john will also purchase a book he will have a book ellie will also purchase a book because the price is lower than how much she's willing to pay but these two guys won't have uh will not have a book at the end so if you check who will have the book at the end it is these three guys who value the book the highest and these two guys who also value the book that is highest so you see that at the end the market and somehow allocate the book toward those who value it the most those who value the book the most are fenn and anya and parisha john and ellie at first we had five books but these two guys also had the book but they valued the book less than these three guys so they sold their books to these three guys and this is how markets like an invisible hand relocates we allocate the items between people somehow at the end everybody who values the book the most will keep the book and will have the book this is why we say that markets are efficient or this is what adam smith believes he believed that the market works somehow that the butcher and the brewer will produce the item and sell it in the market and sell their product to those who value their the product the most um this is the concept of market efficiency market efficiency means that at the end everybody values the item the most will be able to purchase their or keep dying um this is true if markets are uh competitive in fact we can show that in a company competitive markets are efficient competitive market is this is an informal definition of competitive market or markets that we have many sellers and buyers somehow that they do not have market power to uh to change their prices their price takers so when we had uh the when we had a supply and demand curve like this we have many buyers and sellers and price determines in equilibrium not a single buyer or a single seller can change the price or when we talked about uh our example here you see that fatima alan umar fenn and anya we assume that they cannot change their prices for example fatima we assume that fatima can not sell the book at a different price than 30 in practice she can maybe she goes into the market and asks for 35 instead of 45 instead of 30 but here the assumption is that the players are small there are many buyers and many sellers so that not a single person can change the prices this is a hypothetical market a competitive market is a hypothetical market where we assume that there are many small buyers and sellers in the market one example may be a farmer's market so there are many producers of vegetables and there are many buyers of vegetables so not a single farmer can change the price of for example a tomato in the market if they change the price of tomato you will go and purchase from another another seller so at the end price is kind of constant for the farmer another example maybe uber so there are many buyers and many sellers and price somehow determines in the market it's not totally determined in the market in fact uber is the uh uber company is a place where is the one who assigned the prices for buyers and sellers but you can assume that it is kind of market equilibrium and drivers and passengers are price taker they cannot themselves change the prices so if we have a competitive market we can show that markets are efficient what does that mean it means that the sum of consumer and producer surplus is at its maximum we cannot increase the consumer and producer surplus anymore let's see how does consumer and producer surplus looks like in a competitive market so when we have many buyers and many sellers the demand and supply look like this this is q this is p this is demand this is supply and um the surplus from the first unit this is the marginal willingness to pay this is marginal cost from the first unit the surplus or module willingness to pay is this much but the cost is this much so this will be the surplus from the first unit what about the second unit so willingness to pay is this much so if you give the item to the second person you will enjoy the item this much but the opportunity cost of producing the item is this much and if you continue these surpluses you see that this will be total surplus that is this area the marginal willingness to pay surplus is marginal willingness to pay minus marginal cost or let's see so surplus equals marginal winningness to pay minus p plus p minus marginal cost i just add and subtract the price and you can see that this is consumer surplus and this is producer surplus let's check it here this is the equilibrium price marginal willingness to pay minus p is consumer surplus so for the first unit this is the consumer surplus what is the producer surplus for the first unit this is the price that producer or seller receives and this is the cost of producing or selling the item so this will be producer surplus and this will be the consumer surplus but only for the first item if we want to uh see how much are the total consumer producer surplus we see that this is the equilibrium quantity and there will be this much of uh sales in the market so in total this area is producer surplus and this area is total consumer surplus why do i say that surplus is at its maximum in this point consider the case where you're not at this point so consider consider suppose we produce at the quantity that is larger than equilibrium quantity suppose we produce here at this point you see that the cost of providing the good the marginal cost of providing the good is larger than the benefit of selling a good the willingness to pay is lower than its cost so it is better not to sell this product because it will have a negative surplus for us so at this point the surplus is negative so it is better for us to reduce total production not produce this item not produce this item and produce exactly at this point what about here what about this at this point the willingness to pay for the item is larger than the cost of producing the item so it is better for us to produce the item because the benefit of that is larger than the cost of it so it is better to increase production and produce exactly at this point where marginal cost of production is exactly the same as marginal benefit of the production at this point the surplus is at its maximum at this point surplus is lower than its maximum and at this point we have some negative surplus so again it is lower than what it is efficient and exactly at the market equilibrium is where total surplus total surplus is this one area is at x maximum um so this is why we call markets are efficient at equilibrium this is why we say that the markets uh like an invisible hand maximize the social benefit and this is so important that we give this theory a very specific name and that is first the first fundamental theory of welfare that is such an important theory in economics and the theory is that a competitive market is efficient it maximizes the surplus if markets are efficient then what you should do you should just let the market work let it work and at the end you will see everybody who wants the item and values the item the most can have the item and if you uh ruin the market if you do not let the market work then you will produce some inefficiency let's see for example what can we do to produce inefficiency in the market this is q this is p again uh let me draw a more inelastic demand this is demand is supply p and q uh let's see if price is here total surplus producer surplus is let's call it a b c and d and e so if we're at equilibrium producer surplus is the area between price and supply so that's a plus b if we are at equilibrium so price is ps star q is qs star and if you are at equilibrium produces surpluses at the area between price and supply that is a plus b consumer surplus is c plus d plus e and we believe that this is the maximum produced asset suppose for some reason the suppliers decide to produce less or the government can reduce total amount of supply suppose suppliers decide to produce less an example could be opaque that's a supplier of oil decided to produce less oil so they decide to produce q1 instead of qstar what will be their new price at q1 people are willing to pay this much and we can conclude that the suppliers can sell their products at price of p1 which is larger than psr because they reduce the amount of production they can sell their product at p1 and that's because people are willing to pay up to p1 for q1 amount of production so this is at psr and qsr what about at q1 and p1 producer surplus is the price is now p1 but the cost is this much the marginal cost is lower so for the first unit that they sell this will be the surplus for the second unit this will be the surplus third unit surplus and so on so total producer surplus at this point will be a plus d that is the area between price and surplus why i do not add cnb to that because they won't sell more than q1 so they cannot benefit from this area what is consumer surplus now price is higher they cannot consume more than q1 and consumer surplus will be just e what is the changing producer surplus compared to uh the first case so change in producer surplus will be a plus b minus a plus d that is b minus d so they lose the producer lose this area and gain this area so that will be p minus d so compared to before let me write produces a plus this way so it is now a plus d previously it was a plus b so it is d minus b they gained d and lost b in the figure that i draw d is larger than b and it is positive so they benefit from this uh cartel or reduction in total production why was that so because demand was elastic they can increase the price without reducing the quantity that they sell very much what is changing consumer surplus consumer surplus is e it was c plus d plus e so it is minus c plus e that is negative consumers see plus d sorry so this should be consumers lose this area so consumers lost something but producers earned something but how much is the change in total surplus total surplus is now uh e plus d plus a but before it was the entire area so it was e plus d plus c plus a plus b this was total surplus and you see that we lost this area of produces are plus so we lost b plus c and that is lower than zero so you see that by reducing the quantity we are losing some surplus and our total surplus will drop and this is called the area that we lose is called that weight loss they will talk in more details in the next session um so so far what do we have we see that competitive markets are efficient what does that mean it means that everybody who values the item the most will have the item so what can we conclude we conclude that if the assumptions of competitiveness are correct what we should do is we should let the market work just let people trade with each other and that is where we see the maximum benefit maximum social benefit this is what adam smith said in the beginning right let's go back to the adam smith's quote the rich consume little more than the poor and and in spite of their natural selfishness and capacity they divide before the product of all their improvement they're led by an invisible hand to make nearly the same distribution of necessary of life which would have been made had the earth been divided into equal portions among all its inhabitants and thus without intending it without knowing it advanced interests of society advance total surplus and afford means to the multiplication of this species so he believed that if we let the market work will advance the interests of society and we show that in fact this is the case in our simplified model but what is the problem that the problem is that this simplified model is not anything that we need markets are usually not competitive so that's just a simplifying assumption so when markets are not competitive we cannot have the efficiency conclusion the other assumption was that the surplus was the marginal benefit minus marginal cost but marginal benefit is not necessarily the same as marginal social benefit and marginal cost is not necessarily the same as marginal social cost in that case the surplus in a market is not where we see the is not where the tool the surplus is the the market equilibrium is not the point where the total surplus is maximized can you think of a situation where marginal benefit is not the same as marginal social benefit suppose suppose for example if you go to the college you you can have uh you you by going to the college and paying for the tuition fee you will have some benefit so if this is your demand for going to college and this is the price of college you will receive some benefit this is uh consumer surplus you are willing to pay for the college then it's actual price and the difference is how much you benefit from going to the college but you can also have some social benefit maybe the college teaches you something that you can give back to the society like you can innovate something you can you can build something new in future in that case the social benefit of you will be larger than your marginal willingness to pay you will have some positive externality on other people for example if you can find a new drug for example in the future uh okay your economies in the future maybe you can find a better way to allocate resources to the poor then you will have a huge social benefit for others by just going to the college so your value your marginal benefit of education your marginal social benefit will be larger than your marginal private benefit in that case we cannot conclude that markets are efficient anymore because in the supply and demand care here we have marginal willingness to pay of each individual if we assume that module people do not have externalities or the cost of production does not have any externality on other thing then we can conclude that markets are efficient but otherwise we cannot conclude that so can you think of another example where uh private cost of production marginal cost of production is different from marginal social cost of production pollution is an example the private cost of producing pollution is different from the social cost of reducing pollution in that case we have negative externalities and markets are not efficient again another point is that efficiency is different from fairness so you see that um everybody who values the item the most will get the item at the end but this is in terms of dollars is it fair to give the item to the person who is willing to pay the highest for example uh bill gates may be willing to pay for uh an item for a textbook far more than you but is it fair to give the item to the to bill gates he's richer he's willing to pay more uh but is it fair to give it to bill gates maybe bill gates is willing to was willing to pay thousands of dollars to the first vaccine that produced but it is not necessarily fair to give it to bill gates maybe it was fair to give it to them a person who is working at the hospital so that's important efficiency is not fairness and also the surplus that we uh that we calculated was in terms of dollars not in terms of well-being what does it mean so i'm sure that if you uh take if you ask bill gates to give a couple of thousand dollars to a poor person this social well-being will grow but not total surplus total surplus does not increase if you just take money from bill gates and give it to a poor person because you take thousand dollars and give it give thousand dollars to a poor person the surplus remains the same in terms of dollars so you just reduce thousand dollars surplus from bill gates and increase thousand dollars surplus to a poor person the surplus remains the same but well-being does not remain the same so it is important to remember that surplus is different from well-being so all i said we had a very important theory that markets are efficient surplus is maximizing a competitive market but you should be careful that this is not the end of the story there are some uh limitations uh to our definition of fair entire definition of efficiency and our assumptions about the market