UNIT 7 & 8: PART 3
EFFICIENCY AND FAIRNESS
GAINS FROM TRADE:
- When economic interactions are voluntary, they generally benefit both participants.
- The buyer will pay a price up to her willingness to pay (WTP).
o WTP is determined by her income, prices of other goods and her preferences
(i.e. utility gain from the item relative to alternative uses of the money).
- The seller will accept a price as low as his willingness to accept (WTA).
o This is determined by the costs of providing the item, which in turn depends
on technology and the prices of inputs.
- A buyer and seller of an item can both benefit if the value of the item to the buyer is
more than the costs to the seller of supplying the item.
o WTP > WTA
- The difference WTP − WTA is the surplus created by the transaction and it measures
the gains from trade.
- How the surplus is divided between the seller and the buyer depends on the price
(P):
o Consumer surplus = WTP − P
o Producer surplus = P − WTA
- Surpluses can be regarded as rents, and they are an incentive to trade
o participants are better off compared to the reservation option (not trading)
- When surplus is positive,
o rational participants will choose to trade if a mutually beneficial price can be
agreed upon.
o trade would be a Pareto improvement.
o failing to exploit gains from trade would be inefficient.
WHAT ABOUT FAIRNESS?
Two issues arise:
- The gains to the buyer and the seller may be distributed unfairly
- Not everyone can have the same opportunity to benefit from trade in markets
o A person with no money/ resources cannot get gains from trade!
GAINS FROM TRADE
- In markets there can be many buyers and sellers
- Buyers may differ in their WTPs for different units
, CONSUMER SURPLUS:
- Demand curve (D) is willingness to pay (WTP)
- Consumer surplus (CS): obtained when a consumer pays
less than what he/she is willing to pay
(WTP > P)
- CS = WTP – P
- Total CS is sum of all the CS generated by all the cars
sold
- Consumer surplus: Area between demand curve and price
- (the shaded area)
- Consumer surplus = area of a triangle
½ x 32 x (8000 – 5440)
= $40 960
PRODUCER SURPLUS:
- A producer is willing to see a unit as long a the P at least
covers the cost of producing that unit (MC), so WTA = MC
- Producer surplus: the amount the producer receives over and
above WTA producer surplus contributed by a unit = P – MC
- E.g. if P = 3360, producer surplus of 20th car = 3360 – MC
= 1056
- Total PS is sum of PS generated from all units sold
- Producer surplus is the area above the MC curve and below the
price
- If P = 3360 and 42 cars are sold:
PS = ½ x 42 x (3360 – 1344)
= $42 336
GAINS FROM TRADE IN COMPETITIVE EQUILIBRIUM:
- Consider the perfectly competitive market for bread
- A competitive equilibrium allocation of bread has the property that total surplus is
maximized
- Total surplus (TS) = CS + PS
- Consumer surplus:
o Buyer’s WTP > price
CS = (€4.25 − €2.5) × 3 760 × ½
= €3 290
- Producer surplus:
o Seller’s MC <price
PS = (€2.5 − €1) × 3 760 × ½ = €2 820
- TS = €3 290 + €2 820 = €6 110
EFFICIENCY AND FAIRNESS
GAINS FROM TRADE:
- When economic interactions are voluntary, they generally benefit both participants.
- The buyer will pay a price up to her willingness to pay (WTP).
o WTP is determined by her income, prices of other goods and her preferences
(i.e. utility gain from the item relative to alternative uses of the money).
- The seller will accept a price as low as his willingness to accept (WTA).
o This is determined by the costs of providing the item, which in turn depends
on technology and the prices of inputs.
- A buyer and seller of an item can both benefit if the value of the item to the buyer is
more than the costs to the seller of supplying the item.
o WTP > WTA
- The difference WTP − WTA is the surplus created by the transaction and it measures
the gains from trade.
- How the surplus is divided between the seller and the buyer depends on the price
(P):
o Consumer surplus = WTP − P
o Producer surplus = P − WTA
- Surpluses can be regarded as rents, and they are an incentive to trade
o participants are better off compared to the reservation option (not trading)
- When surplus is positive,
o rational participants will choose to trade if a mutually beneficial price can be
agreed upon.
o trade would be a Pareto improvement.
o failing to exploit gains from trade would be inefficient.
WHAT ABOUT FAIRNESS?
Two issues arise:
- The gains to the buyer and the seller may be distributed unfairly
- Not everyone can have the same opportunity to benefit from trade in markets
o A person with no money/ resources cannot get gains from trade!
GAINS FROM TRADE
- In markets there can be many buyers and sellers
- Buyers may differ in their WTPs for different units
, CONSUMER SURPLUS:
- Demand curve (D) is willingness to pay (WTP)
- Consumer surplus (CS): obtained when a consumer pays
less than what he/she is willing to pay
(WTP > P)
- CS = WTP – P
- Total CS is sum of all the CS generated by all the cars
sold
- Consumer surplus: Area between demand curve and price
- (the shaded area)
- Consumer surplus = area of a triangle
½ x 32 x (8000 – 5440)
= $40 960
PRODUCER SURPLUS:
- A producer is willing to see a unit as long a the P at least
covers the cost of producing that unit (MC), so WTA = MC
- Producer surplus: the amount the producer receives over and
above WTA producer surplus contributed by a unit = P – MC
- E.g. if P = 3360, producer surplus of 20th car = 3360 – MC
= 1056
- Total PS is sum of PS generated from all units sold
- Producer surplus is the area above the MC curve and below the
price
- If P = 3360 and 42 cars are sold:
PS = ½ x 42 x (3360 – 1344)
= $42 336
GAINS FROM TRADE IN COMPETITIVE EQUILIBRIUM:
- Consider the perfectly competitive market for bread
- A competitive equilibrium allocation of bread has the property that total surplus is
maximized
- Total surplus (TS) = CS + PS
- Consumer surplus:
o Buyer’s WTP > price
CS = (€4.25 − €2.5) × 3 760 × ½
= €3 290
- Producer surplus:
o Seller’s MC <price
PS = (€2.5 − €1) × 3 760 × ½ = €2 820
- TS = €3 290 + €2 820 = €6 110
