A BROKEN LASER POINTER STARTS AN INTERNET REVOLUTION

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1 chapter 5 Efficiency LEARNING OBJECTIVES LO 5.1 LO 5.2 LO 5.3 LO 5.4 LO 5.5 LO 5.6 LO 5.7 LO 5.8 Use willingness to pay and willingness to sell to determine supply and demand at a given price. Calculate consumer surplus based on a graph or table. Calculate producer surplus based on a graph or table. Calculate total surplus based on a graph or table. Define efficiency in terms of surplus, and identify efficient and inefficient situations. Describe the distribution of benefits that results from a policy decision. Define and calculate deadweight loss. Explain why correcting a missing market can make everyone better off. A BROKEN LASER POINTER STARTS AN INTERNET REVOLUTION In 1995, a young software developer named Pierre Omidyar spent his Labor Day weekend building a website he called AuctionWeb. His idea was to create a site where people could post their old stuff for sale online and auction it off to the highest bidder. Soon after, he sold the first item on AuctionWeb for $ It was a broken laser pointer, which he had posted on the site as a test, never expecting anyone to bid on it. When Pierre pointed out that the pointer was broken, the bidder explained that he was a collector of broken laser pointers. As you might have guessed, AuctionWeb became the wildly successful company we now know as ebay. In 27, the total value of items sold on ebay was nearly $6 billion, or $1,9 every second; 84 million people around the world were active users. Like many creation stories, the tale of ebay s first sale gives us insight into what makes it tick. People are interested in some pretty odd things (like broken laser pointers), but given a big enough audience, someone who wants to sell can usually find someone who wants to buy. When buyers and sellers are matched up and they trade, each is made better off. The buyer gets an item he wants, and the seller gets money. Because both parties benefit from engaging in such transactions, they are willing to pay ebay to provide the marketplace where they can find one another. 141 kar11498_ch5_ indd 141

2 142 PART 2 Supply and Demand ebay s success is based on one of the most fundamental ideas in economics, and its importance stretches far beyond the company itself: Voluntary exchanges create value and can make everyone involved better off. This principle drives a range of businesses that do not manufacture or grow anything themselves, but instead facilitate transactions between producers and consumers from grocery stores, to investment banks, to online retailers. But this principle raises a question: How do we know that people are better off when they buy and sell things? Can we say anything about how much better off they are? FPO To answer these questions, we need a tool to describe the size of the benefits that result from transactions and who receives them. In this chapter we will introduce the concept of surplus, which measures the benefit that people receive when they buy something for less than they would have been willing to pay or sell something for more than they would have been willing to accept. Surplus is the best way to look at the benefits people receive from successful transactions. Surplus also shows us why the equilibrium price and quantity in a competitive market are so special: They maximize the total well-being of those involved. Even when we care about outcomes other than total well-being (like inequality in the distribution of benefits), surplus gives us a yardstick for comparing different ideas and policies. For instance, calculations of surplus can clearly show who benefits and who loses from policies such as taxes and minimum wages. As we ll see, efficiency is one of the most powerful features of a market system. Even more remarkable is that it is achieved without centralized coordination. Surplus also shows us how simply enabling people to trade with one another can make them better off. Often, creating a new market for goods and services (as we saw, in the opening example in Chapter 1, that the Grameen Bank did in Bangladesh) kar11498_ch5_ indd 142

3 Efficiency CHAPTER or improving an existing market (as ebay did on the Internet) can be a good way to help people. Knowing how and when to harness the power of economic exchanges to improve well-being is an important tool for business people and public-minded problem solvers alike. Willingness to Pay and Sell LO 5.1 Use willingness to pay and willingness to sell to determine supply and demand at a given price. ebay is an online auction platform that allows people to create a web page advertising an item for sale. People who want to buy the item make bids offering to pay a particular price. This decentralized marketplace supports all sorts of transactions: from real estate, to used cars, to rare books, to (in one extraordinary case) a halfeaten cheese sandwich said to look like the Virgin Mary (which sold for $28,). Who uses ebay? What do they want? At the most basic level, they are people who want to buy or sell a particular good. We re not sure what s going on with people who want broken laser pointers or moldy cheese sandwiches, so let s stick with something a little more typical. How about digital cameras? (Just as we did in Chapter 3, we ll make the simplifying assumption that there is just one kind of digital camera rather than thousands of slightly different models.) Imagine you see a digital camera posted for sale on ebay. Who might bid on it? What are their wants and constraints? Most obviously, people who bid will be those who want a camera. But they will also care about the price they pay: Why spend $2 for a camera if you can get it for $1 and spend the other $1 on something else? Potential buyers want to pay as little as possible, but on top of this general preference, each buyer has a maximum price she is willing to pay. Economists call this maximum price the buyer s willingness to pay or reservation price. Economists use these two terms interchangeably; in this book, we ll stick with willingness to pay. This price is the point above which the buyer throws up her hands and says, Never mind, I d rather spend my money on something else. Each potential buyer wants to purchase a camera for a price that is as low as possible and no higher than her maximum willingness to pay. On ebay, we can see willingness to pay in action. When the price of a product remains below a bidder s willingness to pay, he ll continue to bid on it. When the going price passes his willingness to pay, he ll drop out. Of course, buyers are only half the story. Who posted the camera for sale on ebay in the first place? To create a functioning market for digital cameras, someone has to want to sell them. Whereas buyers want to buy a camera for as low a price as possible, sellers want to sell for as high a price as possible. Why take less money if you could get more? Just as each potential buyer has a willingness to pay, each potential seller has a willingness to sell. Willingness to sell is the minimum price that a seller is willing to accept in exchange for a good or service. A seller always wants to sell for a price that is as high as possible, but never lower than his minimum. We can see willingness to sell in action on ebay through the reserve price that sellers can set when they post an item. This reserve price sets a bar below which the seller will not accept any bids. If she doesn t get any higher bids, she simply keeps the item. So far, so good: Buyers want to buy low, sellers want to sell high. What does this have to do with markets? We re about to see that willingness to pay and willingness to sell are actually the forces that drive the shape of demand and supply curves. willingness to pay (reservation price) the maximum price that a buyer would be willing to pay for a good or service willingness to sell the minimum price that a seller is willing to accept in exchange for a good or service kar11498_ch5_ indd 143

4 144 PART 2 Supply and Demand Willingness to pay and the demand curve Let s return to potential camera buyers and take a closer look at how they choose to bid on the camera posted on ebay. To keep things simple, let s imagine that there are five buyers who are considering bidding on this particular camera. The first potential buyer is a bird watcher, who cares passionately about having a good camera to document the rare birds she finds. She is willing to pay up to $5 for the camera. The next bidder is an amateur photographer; he has an outdated camera and is willing to pay $25 for this newer model. The third bidder is a real estate agent, who will be willing to pay $2 or less to be able to take better pictures of her properties. Next is a journalist, who wouldn t mind having a newer camera than the one her newspaper provided, but would pay no more than $15 for it. Finally there is a teacher, who will spend no more than $1 the amount of the ebay gift certificate given to him by appreciative parents for his birthday. We can plot each potential buyer s willingness to pay on a graph. In panel A of Figure 5-1, we ve graphed possible prices for the camera against the number of buyers who would be willing to bid that price for it. Remember that each person s willingness to pay is a maximum he or she would also be willing to buy the camera FIGURE 5-1 Willingness to pay and the demand curve (A) Willingness to pay with few buyers (B) Willingness to pay with many buyers Bird watcher Amateur photographer Real estate agent Journalist Each step represents a camera Teacher bought by the additional buyer who becomes interested at that price. 2 Demand Potential buyers At any given price, buyers with a higher willingness to pay will buy and those with a lower willingness to pay will not. If the price were $35, only one buyer would buy. If it were $5, all five people would buy. This demand curve has a step-like shape rather than a smooth line because there are a limited number of buyers whose prices are expressed in round dollar amounts Quantity of cameras (millions) In the real market for a particular model of a digital camera, there are millions of cameras demanded at a particular price. The steps that we see in panel A get smaller and smaller until they disappear into a smooth curve. kar11498_ch5_ indd 144

5 Efficiency CHAPTER at any lower price. Therefore, at a price of $1, all five buyers are willing to bid; at $35, only one will bid. If you squint a bit, you might notice that the graph in panel A looks a lot like a demand curve price on the y -axis, quantity on the x -axis, and a line showing that quantity demanded increases as price decreases. In fact this is a demand curve, albeit one representing only five potential buyers. If we conducted the same exercise in a bigger market and plotted out the willingness to pay of millions of people rather than just five, we d get a smooth demand curve, as shown in panel B of Figure 5-1. Notice that although each buyer s willingness to pay is driven by different factors, we can explain the motivations behind all of their decisions by asking, What are the trade-offs? Money that is spent to buy a camera on ebay cannot be spent on other things. Willingness to pay is the point at which the benefit that a person will get from the camera is equal to the benefit of spending the money on another alternative in other words, the opportunity cost. At prices above the maximum willingness to pay, the opportunity cost is greater than the benefits; at lower prices, the benefits outweigh the opportunity cost. For instance, $25 is the point at which the enjoyment that the amateur photographer gets from a camera is the same as the enjoyment he would get from, say, buying $25 worth of stamps for his stamp collection instead. Since everyone has things they want other than cameras, this same logic applies to each of the potential buyers represented in the demand curve. To figure out which of our five individual buyers will actually purchase a camera, we have to know the market price. To find the market price, we have to know something about the supply of digital cameras. Therefore, we turn next to investigating the supply curve. Willingness to sell and the supply curve As you may have guessed, just as the shape of the demand curve was driven by potential buyers willingness to pay, the shape of the supply curve for digital cameras is driven by potential sellers willingness to sell. To simplify things, let s imagine five particular sellers who have posted their cameras for sale on ebay. The first prospective seller is a comic book collector. He was given a camera as a birthday present, but all he really cares about is having money to spend on comic books. He s willing to part with his camera for as little as $5. Then there s a sales representative from a big company that makes digital cameras. She s authorized to sell for anything $1 or higher. Next is a professional nature photographer, who owns several cameras but won t sell for anything less than $2; at a lower price he d rather give it as a gift to his nephew. Another seller is a sales representative at a smaller company which is just setting up in the camera business and has much higher costs of production than the larger company; it can make money only by selling its cameras for $3 or more. The fifth seller is an art teacher who is sentimentally attached to her camera, given to her by a friend. She won t give it up unless she can get at least $4. We can represent these five individuals by plotting their willingness to sell on a graph. Panel A of Figure 5-2 shows a graph of potential prices and the number of cameras that will be up for bid at each price. This graph is a supply curve representing only five potential sellers. As with the demand curve, if we added all of kar11498_ch5_ indd 145

6 FIGURE 5-2 Willingness to sell and the supply curve (A) Willingness to sell with few sellers (B) Willingness to sell with many sellers Each step represents the additional camera sold by a seller who becomes interested as the price increases. Art teacher 5 4 Supply 3 Sales rep(small company) 3 2 Nature photographer 2 1 Sales rep (big company) Collector Potential sellers At any given price, sellers with a lower willingness to sell will sell, while those with a higher willingness to sell will not. At a price of $4, all five people will sell their cameras, while at a price of $2, only three sell. This rough supply curve would look smooth if there were many sellers, each with a different willingness to sell Quantity of cameras (millions) In the real market for a particular model of a digital camera, there are millions of cameras supplied at a particular price. The steps that we see in panel A get smaller and smaller until they disappear into a smooth curve. the millions of digital cameras that are actually for sale in the real world, we see the smooth supply curve we re accustomed to, as in panel B. Sellers willingness to sell is determined by the trade-offs they face, and in particular, the opportunity cost of the sale. The opportunity cost of selling a camera is the use or enjoyment that the seller could get from keeping the camera or, in the case of the two camera manufacturers, from doing something else with the money that would be required to manufacture it. Each seller s opportunity cost will be determined by different factors not all of them strictly monetary, as in the case of the teacher who is sentimentally attached to her camera. For items that the seller just wants to get rid of, the starting price might be one cent. If opportunity cost is zero, anything is better than nothing! On the other hand, in a market where manufacturers are producing and selling new products, the minimum price will have to be high enough to make it worth their while to continue making new products. If the sale price didn t cover their costs of production, the manufacturers would simply stop making the item otherwise, they would actually lose money every time they made a sale. (Occasionally, we do see manufacturers selling below the cost of production, but only when they ve made a mistake and have to get rid of already-produced goods.) Having met five potential buyers and five potential sellers, we re now in a position to understand what happens when the two groups come together in the market to make trades. But first, take a look at the Real Life box, Haggling and bluffing, to consider how buyers willingness to pay interacts with sellers willingness to sell in the real world. 146 kar11498_ch5_ indd 146

7 Efficiency CHAPTER REAL LIFE Haggling and bluffing If you ve ever visited a flea market or bought a used car, you have probably haggled over price. In much of the world haggling for goods is an integral part of daily life. Even in wealthy countries, bargaining over salaries and promotions is commonplace employees offer to sell their time and skills, and employers offer to buy them. In any bargaining situation, the seller wants to sell for as high a price as possible, and the buyer wants to buy for as low a price as possible. How do they reach an agreement? The idea of willingness to pay explains a lot of bargaining strategies. Usually, the seller will start with a price much higher than the minimum she is actually willing to accept. Likewise, the buyer starts with an offer much lower than what he is actually willing to pay. Neither will reveal the price he or she thinks is reasonable. Isn t this a waste of time? They both know that they ll end up somewhere in the middle. Why not just start there? Put yourself in the shoes of a flea-market vendor. If you knew for certain how much a potential customer was willing to pay, would you accept anything short of that amount? Probably not. As the would-be buyer, then, you have a strong incentive to make sure that the vendor doesn t know your true willingness to pay. The same is true for the vendor, who wants to hide from the potential buyer the minimum price he ll accept. Both parties start bidding far from their actual reservation price, hoping to end up with the most favorable price possible. The same principle also explains a trick that is sometimes used by hagglers: bluffing about your willingness to pay. What would you do if the cost of an item were above your maximum willingness to pay? On ebay, you d stop bidding; in the flea market, you d walk away. Walking away from the bargaining table signals that the current price is higher than your willingness to pay whether or not that is truly the case. If the seller realizes he won t get a higher price, he will sometimes settle rather than lose the sale entirely. On the other hand, if you re a bad bluffer or if your offered price is below the seller s willingness to sell, you lose the deal. The next time you hear that labor has walked out on talks in a union wage negotiation or that a party to a civil lawsuit has withdrawn from mediation, you will know that they re signaling their minimum or maximum price. The question is, are they bluffing? CONCEPT CHECK How is willingness to pay determined by opportunity cost? [LO 5.1] What is the relationship between willingness to pay and the demand curve? [LO 5.1] Measuring Surplus Surplus is a way of measuring who benefits from transactions and by how much. Economists use this word to describe a fairly simple concept: If you get something for less than you would have been willing to pay, or sell it for more than the minimum you would have accepted, that s a good thing. Think about how nice it feels surplus a way of measuring who benefits from transactions and by how much kar11498_ch5_ indd 147

8 148 PART 2 Supply and Demand to buy something on sale that you would have been willing to pay full price for. That bonus value that you would have paid if necessary, but didn t have to, is surplus. We can talk about surplus for both buyers and sellers, individually and collectively. Surplus is the difference between the price at which a buyer or seller would be willing to trade and the actual price. Think about willingness to pay as the price at which someone is completely indifferent between buying an item and keeping his money. At a higher price, he would prefer to keep the money; at a lower price, he would prefer to buy. By looking at the distance between this indifference point and the actual price, we can describe the extra value the buyer (or the seller) gets from the transaction. Surplus is a simple idea, but a surprisingly powerful one. It turns out that this is a better measure of the value that buyers and sellers get from participating in a market than price itself. To see why this is true, read the From Another Angle box, How much would you pay to keep the Internet from disappearing? FROM ANOTHER ANGLE How much would you pay to keep the internet from disappearing? Why is surplus a better measure of value than how much we pay for something? Consider the difference between what we pay for the Internet versus a particular model of computer. Most people can access the Internet for very little, or even for free. You might pay a monthly fee for high-speed access at home, but almost anyone can use the Internet for free at schools, libraries, or coffee shops. Once you re online there are millions of websites that will provide information, entertainment, and services at no charge. Computer owners, on the other hand, pay a lot for particular types of computers. For instance, consumers pay $999 for a MacBook laptop. Does this mean that we value access to the Internet less than a MacBook? Probably not. To see why simply measuring price falls short of capturing true value, think about how much you would pay to prevent the particular type of computer you own from disappearing from the market. You might pay something: After all, there s a reason you chose it in the first place, and you might be willing to cough up a bit extra to get your preferred combination of technical specifications, appearance, and so on. But if the price got very steep, you d probably rather switch to another, similar type of computer instead of paying more money. That difference the maximum extra amount you would pay over the current price to maintain the ability to buy something is your consumer surplus. It is the difference between your willingness to pay and the actual price. Now consider the same question for the Internet. Imagine that the Internet is going to disappear tomorrow, or at least, that you will be unable to access it in any way. How much would you pay to keep that from happening? Remember, that means no , no Google search or maps, no Facebook, no Twitter, no YouTube, no video streaming, and no online shopping. We suspect that you might be willing to pay a lot. The amount that you re willing to pay represents the true value that you place on the Internet, even though the amount that you currently spend on it might be very little. That s the magic of surplus. kar11498_ch5_ indd 148

9 Efficiency CHAPTER Consumer surplus LO 5.2 Calculate consumer surplus based on a graph or table. Let s go back to our five ebay buyers and calculate the surplus they would receive from buying a camera at a given price. Suppose it turns out that the going rate for cameras on ebay is $16. The bird watcher was willing to bid up to $5. Therefore, her consumer surplus from buying the camera is $34 the difference between her willingness to pay and the $16 she actually pays. Two other potential buyers will also buy a camera if the price is $16: the real estate agent (willing to pay up to $2) and the amateur photographer (willing to pay $25). The consumer surplus they receive is $4 and $9, respectively. The other two potential buyers will have dropped out of bidding when the price rose above $1 and then above $15, so they buy nothing and pay nothing. Their consumer surplus is zero. We can add up each individual s consumer surplus to describe the overall benefits that buyers received in a market. (Confusingly, economists use the same term for individual and collective surplus, but you should be able to tell from the context whether we mean one person s consumer surplus or total consumer surplus for all buyers in the market.) If the market for digital cameras consisted only of our five individuals, then the total consumer surplus would be: $34 1 $9 1 $4 1 $ 1 $ 5 $47 Panel A in Figure 5-3 shows consumer surplus for these five individuals when the price is $16. Consumer surplus is represented graphically by the area underneath the demand curve and above the horizontal line of the equilibrium price. How does a change in the market price affect buyers? Since buyers would always prefer prices to be lower, a decrease in price makes them better off, and an increase in price makes them worse off. Some people will choose not to buy at all when prices rise which means that their surplus becomes zero. Those who do buy will have a smaller individual surplus than they had at the lower price. The opposite is true when prices fall. Measuring consumer surplus tells us how much better or worse off buyers are when the price changes. Panel B of Figure 5-3 shows what happens to total consumer surplus if the going price of cameras on ebay falls to $1. You can see by comparing panel A and panel B that when the price level falls, the area representing consumer surplus gets bigger. The consumer surplus of each of the three buyers who were already willing to buy increases by $6 each, and an additional two buyers join the market. The journalist gains consumer surplus of $5, because her willingness to pay is $15. The teacher buys a camera but gains no consumer surplus, because the price is exactly equal to his willingness to pay. When the camera s price was $16, consumer surplus was $47. When the camera s price drops to $1, total consumer surplus among our five individuals increases by $23. Producer surplus $47 1 $6 1 $6 1 $6 1 $5 1 $ 5 $7 LO 5.3 Calculate producer surplus based on a graph or table. Like buyers, sellers want to increase the distance between the price at which they are willing to trade and the actual price. Sellers are better off when the market price is higher than their minimum willingness to sell. Producer surplus is the net benefit that a producer receives from the sale of a good or service, measured by the consumer surplus the net benefit that a consumer receives from purchasing a good or service, measured by the difference between willingness to pay and the actual price For a refresher on the area under a linear curve, see Appendix D, Math Essentials: The Area under a Linear Curve, which follows this chapter. producer surplus the net benefit that a producer receives from the sale of a good or service, measured by the difference between the producer s willingness to sell and the actual price kar11498_ch5_ indd 149

10 FIGURE 5-3 Consumer surplus (A) Consumer surplus at $16 (B) Consumer surplus at $ Bird watcher s surplus Total consumer surplus at a price of $ Amateur photographer s surplus Additional surplus for buyers who would have bought at $16 $ Real estate agent s surplus Consumer surplus for the new buyers Potential buyers This graph shows consumer surplus in the camera market when price is $16. The shaded area is the difference between willingness to pay and the market price for each buyer. The more that a buyer would have been willing to pay, the greater the surplus at a lower price. At this price, total consumer surplus is $ Potential buyers When the price of cameras falls to $1, consumer surplus increases. Area 1 is consumer surplus under the old price. Area 2 is the additional surplus received by people who were willing to buy at either price. Area 3 is the surplus received by the two new buyers who enter the market when price falls. The combination of the three areas is total consumer surplus when price is $1. When the price falls, total consumer surplus increases from $47 to $7. difference between willingness to sell and the actual price. It s called producer surplus regardless of whether the sellers actually produced the good themselves, or as often happens on ebay are selling it second-hand. If our five potential sellers find that the going price of cameras on ebay is $16, two of them will sell and will be happy because they will get more for their cameras than the minimum they were willing to accept. The comic book collector, whose willingness to sell is $5, has a producer surplus of $11. The sales rep for the bigger camera company with willingness to sell of $1 has a surplus of $6. The three potential sellers who won t trade at this price have a surplus of zero. If our five sellers are the only ones in the market, then total producer surplus at this price level is: $11 1 $6 1 $ 1 $ 1 $ 5 $17 15 A change in the market price affects sellers in the opposite way it affects buyers. Sellers would always prefer prices to be higher, so a decrease in price makes them worse off. Some will choose not to sell at all when prices fall; their surplus becomes zero. Those who do sell will have a smaller individual surplus than at the higher price. The opposite is true when the market price rises, which makes sellers better off. Measuring producer surplus tells us how much better or worse off sellers are when the price changes. Panel B in Figure 5-4 shows what happens to producer surplus if the price drops from $16 to $1. The two sellers still sell, but their surplus is reduced. Total producer kar11498_ch5_ indd 15

11 FIGURE 5-4 Producer surplus (A) Producer surplus at $16 (B) Producer surplus at $ $ 16 1 $ 5 1. Collector s surplus Big-company rep s surplus Surplus lost by collector and bigcompany rep Collector s surplus Potential sellers Potential sellers This shows the willingness to sell of all the potential sellers in our market.the shaded area (1+2) between the supply curve and the market prices shows total producer surplus of $17. Because sellers always prefer a higher price, producer surplus goes down when the price falls to $1. At $1, two sellers are still willing to sell, but are worse off because they receive less money for their cameras. Area 4 shows the new producer surplus: $5. Area 5 shows the reduction in surplus for the two sellers. surplus falls to $5. Notice that producer surplus is represented graphically by the area underneath the horizontal line of equilibrium price and above the supply curve. The higher the price, the bigger the area, and the greater the producer surplus. Total surplus LO 5.4 Calculate total surplus based on a graph or table. We now understand how to calculate consumer surplus and producer surplus at any given price. But what will the actual market price be? To find out, we have to put the demand and supply curves together and locate the point where they intersect. Let s broaden our focus beyond just five buyers and sellers to the entire market for digital cameras on ebay. To represent this big market, we can bring back the smooth demand and supply curves from Figures 5-1 and 5-2. When we put the two together in Figure 5-5, we find that the equilibrium price is $2, and the equilibrium quantity of cameras traded is 3 million. (We re assuming a standardized model of digital camera and all the other features of a competitive market outlined in Chapter 3.) Total consumer surplus is represented graphically by the area underneath the demand curve and above the equilibrium price. That s the area shaded gold in 151 kar11498_ch5_ indd 151

12 FIGURE 5-5 Surplus at market equilibrium 6 5 Producer surplus Consumer surplus $ 4.5 billion $ 3 billion S D Quantity of cameras (millions) At the market equilibrium, the price of cameras is $2, and 3 million are bought and sold. Consumer surplus is represented by the area between the demand curve and the market price and is equal to $4.5 billion. Producer surplus is equal to the area between the supply curve and the market price and is equal to $3 billion. Total surplus adds up to $7.5 billion. To improve your understanding of consumer, producer, and total surplus, try the interactive graphing tutorial at karlanmorduch. total surplus a measure of the combined benefits that everyone receives from participating in an exchange of goods or services zero-sum game a situation in which whenever one person gains, another loses an equal amount, such that the net value of any transaction is zero 152 Figure 5-5. Total producer surplus is represented by the area of the graph above the supply curve and below the equilibrium price the area shaded blue. Added together, those two areas consumer surplus and producer surplus make up the total surplus created by those 3 million sales of digital cameras on ebay. Total surplus is a measure of the combined benefits that everyone receives from participating in an exchange of goods or services. We can also think of total surplus as value created by the existence of the market. Total surplus is calculated by adding up the benefits that every individual participant receives ($3 consumer surplus for the bird watcher, plus $15 producer surplus for the comic book collector, and so on). But these benefits exist only as a result of their participation in exchanges in the market. This is an important point, because sometimes people mistakenly think of the economy as a fixed quantity of money, goods, and well-being, in which the only question is how to divide it up among people. That idea is referred to as a zero-sum game. A zero-sum game is a situation in which whenever one person gains, another loses an equal amount, such that the net value of a transaction is zero. Playing poker is an example of a zero-sum game: Whatever one player wins, another player, logically, has to lose. The concept of surplus shows us that the economy generally does not work like a poker game. Voluntary transactions, like selling cameras on ebay, do not have a winner or loser. Rather, both the buyer and seller are winners, since they gain surplus. Everyone ends up better off than they were before. Total surplus cannot be less than zero if it were, people would simply stop buying and selling. kar11498_ch5_ indd 152

13 Efficiency CHAPTER As a rule, markets generate value, but the distribution of that value is a more complicated issue. In the following sections, we will look at what surplus can tell us about the well-being generated by market transactions and by deviations from the market equilibrium. Then, in the next chapter, we ll use these tools to evaluate the effects of some common government policies when they are implemented in a competitive market. Later in the book, we will revisit some of the assumptions about how competitive markets operate, and we will discuss what happens to surplus when those assumptions don t hold true in the real world. First, for a real-world recap of some of the ideas we ve encountered so far in this chapter, read the Real Life box, Airwaves that cost $2 million. REAL LIFE Airwaves that cost $2 million We ve seen the auction process in action with private buyers and sellers on ebay. But auctions can be an important public policy tool, too. Take, for instance, an auction in the summer of 28, in which the U.S. government raised almost $2 million by selling the right to broadcast over the public airwaves. According to U.S. law, the public owns the airwaves that are used for radio, television, and broadband Internet transmission. But private companies such as radio and television stations and Internet service providers provide most of the services that use the airwaves. Until 1994, the federal government gave away, for free, the right to use these airwaves to companies they chose through lotteries and hearings. Since then, the government has instead used auctions to sell the rights. In 28, this process raised $19.6 million. We can explain what happened here using the concept of surplus. Even when the federal government gave away rights to the airwaves for free, a transaction was occurring, at a price of zero dollars. This is the ideal situation from a buyer s perspective the lower the price, the better! Companies that acquired rights for free before 1994 would almost certainly have been willing to pay something for them. At a price of zero, that willingness to pay was converted directly into consumer surplus. When the government began auctioning the airwaves rather than giving them away, the price increased above zero. Some of that consumer surplus was turned into producer surplus. In this case, of course, the producer is the government, or the citizens who benefit from public services paid for by government revenue. By forcing companies to bid for the rights, the auction process pushed the market price up closer to the buyers willingness to pay. Thus, the new auction policy was very effective at transferring surplus from the broadcasting companies to the public purse. It s no surprise that governments all over the world are increasingly using auctions to allocate public resources, from airwaves to oil reserves, public lands, and even the right to pollute. Source: CONCEPT CHECK What consumer surplus is received by someone whose willingness to pay is $2 below the market price of a good? [LO 5.2] What is the producer surplus earned by a seller whose willingness to sell is $4 below the market price of a good? [LO 5.3] Why can total surplus never fall below zero in a market for goods and services? [LO 5.4] kar11498_ch5_ indd 153

14 154 PART 2 Supply and Demand Using Surplus to Compare Alternatives In a competitive market, buyers and sellers will naturally find their way to the equilibrium price. In our ebay example, we expect that buyers and sellers of digital cameras will bargain freely, offering different prices until the number of people who want to buy is matched with the number of people who want to sell. This is the invisible hand of market forces at work, and it doesn t require any ebay manager to coordinate or set prices. But as we re about to see, the magic of the invisible hand doesn t stop there. Market equilibrium and efficiency LO 5.5 Define efficiency in terms of surplus, and identify efficient and inefficient situations. The concept of surplus lets us appreciate something very important about market equilibrium: It is not only the point at which buyers are perfectly matched to sellers; it is also the point at which total surplus is maximized. In other words, equilibrium makes the total well-being of all participants in the market as high as possible. To see why this is so, let s look at what would happen to surplus if, for some reason, the market moved away from equilibrium. Suppose an ebay manager decides to set the price of cameras so that people don t have to go to the trouble of bidding. He decides that $3 seems like a reasonable price. How will potential buyers and sellers respond to this situation? Figure 5-6 shows us. Buyers who wanted FIGURE 5-6 Changing the distribution of surplus 6 Producer surplus 5 Consumer surplus 4 1 Prices above market equilibrium reduce total surplus. S Quantity of cameras (millions) When the price rises above the market equilibrium, fewer transactions take place. The surplus shown in area 2 is transferred from consumers to producers as a result of the higher price paid for transactions that do still take place. The surplus in areas 4 and 5 is lost to both consumers and producers as a result of the reduced number of transactions. D kar11498_ch5_ indd 154

15 FIGURE 5-7 Surplus when price is below equilibrium 6 5 Producer surplus Consumer surplus Deadweight loss 4 S Prices below market equilibrium reduce total surplus. 1 3 D Quantity of cameras (millions) When the price of cameras drops to $1, buyers are willing to purchase 4 million, but sellers want to sell only 15 million. For those who do trade, successful buyers gain surplus of $1.5 billion (area 2) from buying at the lower price, while the sellers lose surplus that same amount.the buyers and sellers who would have traded at equilibrium but no longer do so lose $1.875 billion of combined surplus. Total surplus falls from $7.5 billion to $5.625 billion. 1 million cameras at the equilibrium price of $2 are no longer willing to buy at $3, reducing their consumer surplus to zero. That means that sellers who would have sold those 1 million cameras to buyers also miss out and get producer surplus of zero. For the 2 million cameras that still are sold, buyers pay a higher price and lose surplus. The sellers of those 2 million cameras benefit from the higher price and gain the surplus lost by consumers. Overall, total surplus in the market is lower than it was at the equilibrium price, because there are now 1 million fewer cameras sold. What happens if the interfering ebay manager instead decides to sell ebay digital cameras for $1? As Figure 5-7 shows, buyers are willing to purchase 4 million cameras, but sellers are willing to sell only 15 million, at prices between $1 and $2. Since 15 million fewer cameras sell (compared to equilibrium), buyers and sellers lose the surplus that would have been gained through their sale. For the 15 million transactions that still take place, consumers gain surplus of $1.5 billion ($ million) from buying at a lower price (area 2), which is exactly equal to the surplus the remaining sellers lose from selling at a lower price. The buyers and sellers who would have traded at equilibrium but no longer do so lose $1.875 billion of combined surplus. Breaking this down, we find that the 15 million buyers no longer in the market lose $1.125 billion (area 4) and sellers lose $.75 billion (area 5) in surplus. This $1.875 billion total (areas 4 1 5) in lost surplus is subtracted from the amount of total surplus before the price ceiling. Overall, total surplus falls from $7.5 billion to $5.625 billion. 155 kar11498_ch5_ indd 155

16 156 PART 2 Supply and Demand efficient market an arrangement such that no exchange can make anyone better off without someone becoming worse off In both cases when the price is $3 or when it is $1 total surplus decreases relative to the market equilibrium. In fact, we find this same result at any price other than the equilibrium price. The key is that a higher or lower price causes fewer trades to take place, because some people are no longer willing to buy or sell. The value that would have been gained from these voluntary trades no longer exists. As a result, the equilibrium in a perfectly competitive, well-functioning market maximizes total surplus. Another way to say this is that the market is efficient when it is at equilibrium: There is no exchange that can make anyone better off without someone becoming worse off. Efficiency is one of the most powerful features of a market system. Even more remarkable is that it is achieved without centralized coordination. Changing the distribution of total surplus LO 5.6 Describe the distribution of benefits that results from a policy decision. A reduction in total surplus was not the only interesting thing that happened when the meddling ebay manager moved the price of digital cameras away from equilibrium. Another outcome was reassignment of surplus from customers to producers, or vice versa, for the transactions that did take place. When the price was raised, sellers gained some well-being at the expense of buyers. When it was lowered, buyers gained some well-being at the expense of sellers. In both cases, achieving this transfer of well-being from one group to the other came at the expense of reduced total surplus. When an artificially high price is imposed on a market, it s bad news for consumer surplus. Consumers lose surplus due to the reduced number of transactions and the higher price buyers have to pay on the remaining transactions. The situation for producers, though, is more complex. They lose some surplus from the transactions that would have taken place under equilibrium and no longer do. On the other hand, they gain more surplus from the higher price on the transactions that do still take place. These two effects will compete with one another. Whichever effect wins will determine whether the producer surplus increases or decreases overall. To see why, let s go back to Figure 5-6. Area 1 is surplus that is transferred from consumers to producers. Areas 2 and 3 represent surplus lost to consumers and producers, respectively, from transactions that no longer take place. Whether area 1 is bigger or smaller than area 3 will decide whether producer surplus increases or decreases. That depends on the shape of the demand curve and the supply curve. In this case, we can see that area 1 is bigger than area 3. The effect of the artificially high price was to make sellers better off (at the expense of making buyers even more worse off). The opposite situation occurs when prices are lower than the market equilibrium, which you can see by looking again at Figure 5-7. Fewer transactions take place (because fewer producers are willing to sell), and so both producer and consumers lose some surplus from missed transactions. For the transactions that do still take place, consumers pay less and gain surplus at the expense of producers, who get paid less and lose surplus. Thus, a price below the market equilibrium will always reduce producer surplus. That price might increase or decrease consumer surplus. The outcome depends on how much surplus is gained by those who buy at a lower price compared to what is lost to those who can no longer buy at all. We don t expect ebay managers to start imposing their own prices any time soon that would be contrary to the whole idea of ebay as a decentralized virtual marketplace. But there are times when governments or other organizations do kar11498_ch5_ indd 156

17 Efficiency CHAPTER decide to impose minimum or maximum prices on markets. After all, efficiency is not the only thing we care about; many fundamental public policy questions revolve around possible trade-offs between economic efficiency and other concerns such as fairness and equity. We ll look in much more detail at this in the next chapter. Deadweight loss LO 5.7 Define and calculate deadweight loss. An intervention that moves a market away from equilibrium might benefit either producers or consumers, but it always comes with a decrease in total surplus. Where does that surplus go? It disappears and becomes what is known as a deadweight loss. Deadweight loss is the loss of total surplus that results when the quantity of a good that is bought and sold is below the market equilibrium quantity. Figure 5-8 shows deadweight loss for sales of the cameras on ebay. Any intervention that moves a market away from the equilibrium price and quantity creates deadweight loss. Fewer exchanges take place, so there are fewer opportunities for the generation of surplus. We can calculate deadweight loss by subtracting total surplus after a market intervention from total surplus at the market equilibrium before the intervention. Or we can calculate deadweight loss directly by determining the area of the triangle on a graph. We ll see in the next chapter that deadweight loss is an incredibly important concept for understanding the costs of government intervention in markets, through mechanisms such as taxes and controls on the prices of goods. deadweight loss a loss of total surplus that occurs because the quantity of a good that is bought and sold is below the market equilibrium quantity To improve your understanding of deadweight loss on a supply and demand graph, try the interactive graphing tutorial at karlanmorduch. FIGURE 5-8 Changing the distribution of surplus Deadweight loss S 2 1 Transactions that no longer take place at the new price D Quantity of cameras (millions) Deadweight loss represents the surplus that is lost to both producers and consumers as a result of fewer transactions taking place when the price moves away from equilibrium. Here deadweight loss is equal to the gray shaded area. kar11498_ch5_ indd 157

18 158 PART 2 Supply and Demand Missing markets LO 5.8 Explain why correcting a missing market can make everyone better off. A price change is the indirect cause of deadweight loss in the examples we ve just seen. But the direct cause is actually the reduction in the quantity of cameras traded. The nonequilibrium price causes fewer transactions to take place, and the surplus that would have been generated by those transactions at equilibrium is lost. Now look at the flipside: More voluntary transactions mean more surplus. The deeper lesson of the story is that by enabling transactions to take place, the invention of ebay has created surplus where none had existed before. When there are people who would like to make exchanges but cannot, for one reason or another, we are missing opportunities for mutual benefit. In this situation, we say that a market is missing : There is no place for potential buyers and sellers to exchange a particular good or service. We can think of a missing market as a special case of a market in which quantity is below the equilibrium in this case, at or close to zero. This means that total surplus is lower than it could be if a well-functioning market existed. Markets can be missing for a variety of reasons. Sometimes public policy prevents the market from existing for instance, when the production or sale of a particular good or service is banned. But markets can also be missing or shrunk due to other types of hold-ups: a lack of accurate information or communication between potential buyers and sellers, or a lack of technology that would make the exchanges possible. ebay is an example of how new technology can generate new value by creating or expanding a market. Prior to the existence of the Internet and companies like ebay that enable potential buyers and sellers to find one another online, people s scope for transactions was much more limited. You could hold a garage sale to get rid of your extra stuff; you could go to your local stores or post an ad in a newspaper if you were looking to buy an unusual item. But it was very difficult to find out if someone on the other side of the country was offering a rare product or a better price. ebay allows more buyers to find sellers and vice versa, encouraging more mutually beneficial trades. The idea that we can increase total surplus by creating new markets and improving existing ones has important implications for public policy. Policies and technologies that help people share information and do business more effectively can increase well-being. For instance, ideas like creating a market for small loans by the Grameen Bank or expanding access to cell phones in Indian fishing villages don t just redistribute pieces of the pie to help the poor. Instead, they make the whole pie bigger. Think about the many situations in the world in which new technology, new strategies, and outreach to new clients have created a market that brings value to the people who participate in it. Think also about some controversial situations in which markets don t exist, but could be created, as described in the What Do You Think? box, Kidneys for sale. WHAT DO YOU THINK? Kidneys for sale Markets create value that would not otherwise exist, when buyers and sellers come together to participate in voluntary transactions. The idea that well-functioning markets maximize surplus is an important descriptive fact. But people may have moral and political priorities that go beyond maximizing surplus. In fact, many important public policy questions revolve around trade-offs between economic efficiency and other goals. kar11498_ch5_ indd 158