MARKET EQUILIBRIUM

APPLICATIONS
(Welfare Implications)

By
Eric Ekobor-Ackah Mochiah

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 Consumer Surplus
• If you are asked, how much are you willing to pay for an
iPhone 6, what will be your response?

• If the market price is below what you are willing to pay for
the phone, then your purchase will result in consumer
surplus.

• Consumer Surplus is therefore the difference between the

price that a consumer is prepared to pay and the actual
(market)price paid.

• Total consumer surplus is measured by the area beneath the

demand curve and above the price.

• On a graph, total consumer surplus is the shaded area

beneath the demand curve and above the price 2
 Consumer Surplus

Price Consumer Surplus

Maximum Willingness to Pay for Qo

Po What is paid

Qo Quantity
3
How The Price Affects Consumer Surplus:
Price Decrease
Consumer Surplus at Price P
Price
A

Initial
consumer
surplus
C Consumer surplus
P1
B to new consumers

F
P2
D E
Additional consumer Demand
surplus to initial
consumers
0 Q1 Q2 Quantity
4
Copyright©2003 Southwestern/Thomson Learning
 Producer Surplus
• Producer surplus is the difference between the minimum
price that will entice the producer to produce the commodity
at the existing market price.

• The seller’s cost is the lowest price a seller is willing to accept

for a good. It is also known as the marginal cost of production.

• Producer surplus is the region below the market price but

above the supply curve.

• On a graph, total producer surplus is the shaded area above

the supply curve and below the price.
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How the Price Affects Producer
Surplus: A Price Increase
Producer Surplus at Price P

Price
Additional producer Supply
surplus to initial
producers

D E
P2 F

B
P1
Initial C
Producer surplus
producer to new producers
surplus

0 Q1 Q2 Quantity
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Copyright©2003 Southwestern/Thomson Learning
 Social Welfare And Market
Efficiency
• The social welfare is assumed to be the sum of the producer
and consumer surplus.

• The market is efficient if there is efficient allocation and

equity in the distribution of resources.

• Allocative efficiency is attained if the resource allocation

results in maximizing the total surplus received by all
members of society at the given output level.

• Equity is also attained if there is fairness in the distribution of

well-being among the various buyers and sellers.

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 Social Welfare, Market Efficiency
And Deadweight Loss (DWL)
• The proposition is that social welfare is maximized at the
competitive price and quantity for a good.
– competitive market will yield the most or maximum amount of
consumer and producer surplus in the market.

• Any movement away from the point of equilibrium

reduces market efficiency.

• The loss in allocative efficiency is DWL.

– It is that part of the producer and consumer surplus that cannot be
accounted for: it is lost in the market system.
– It is measured by the loss of consumer surplus and producer surplus
not gained to anyone.

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 Producer and Consumer Surplus
P Consumer surplus =
area of blue triangle =
$10
½($5)(6) = $15
9
8 S
Producer surplus =
7
CS area of red triangle = ½($5)
6 (6) = $15
5
4 PS The combination of
3 producer and consumer
2 surplus is maximized at
1 D
Q market equilibrium
0 1 2 3 4 5 6 7 8

9 8-9
Loss In Efficiency Resulting From
Too High Price

Price Deadweight Loss

Lost
S
New Consumer
Consumer Surplus
Surplus PH

Po Lost Producer
Surplus
New
Producer
Surplus D

QH Qo Quantity
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 Loss in Efficiency Resulting from
Too Low Price

Price Deadweight Loss

Lost
S
Consumer
Surplus
New
Consumer
Surplus
Po Lost Producer
PL Surplus
New
Producer D
Surplus

QL Qo Quantity
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 Producer and Consumer Surplus
P Suppose P=$6 Consumer surplus decreases =
Lost surplus area of blue triangle =
$10
(deadweight loss) = ½($4)(5) = $10
9
½($2)(1) S
8 Producer surplus increases =
7 CS areas of red triangle and
6 rectangle =
5 ½($4)(5)+($2)(5)= $20
4 PS
3 The combination of producer and
2 consumer surplus decreases
1 D when price is greater than
Q equilibrium price
0 1 2 3 4 5 6 7 8

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8-12
 Why Is Equilibrium Best???
• The conclusion is that for the competitive market system, the
equilibrium represents the most allocative efficient point.

• At equilibrium, the output produced ensures that consumer

Surplus and Producer Surplus are maximized.

• Any point other than the equilibrium will result in inefficient

resource allocation and unfair distribution of the surplus
either to the benefit of the consumer or producer.

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 Government Intervention In The
Market
• Governments may intervene if they think the market price
is either too high or too low.

• Government may place legal limits on how high or how low

a price or prices may go.

• These interventions (though conceived with good

intentions) may create problems in the market system.

• To determine the welfare effect of a governmental policy

we can measure the gain or loss in consumer and producer
surplus.

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 Maximum price control/ price
ceiling
• A price ceiling is a legal maximum that can be charged for a
good. It is the maximum acceptable price above which no
good or service is suppose to sell.

• A price ceiling establishes a maximum price that sellers are

legally permitted to charge.

• A price ceiling occurs when government sets a price for the

market that is below the equilibrium price.

• The Direct effect is a shortage: the quantity demanded will

exceed the quantity supplied. Waiting lines may develop.

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 Government Intervention In
Housing Market
Price Controls:
Price Maximum Prices
S
below normal equilibrium
Black Market
Price Suppliers reduce the
$180 Assume
amountthe equilibrium
offered to 60 but
Shortages
price is $100
demand may
and
would the
riselead to
to 140
The government
black
amount market
bought
creating andimposes
prices
a shortage sold is 100
of 80 –
arationing
maximum
way above price of $60
thehave to be
might
$100 (P Max)
equilibrium
introduced free market
level
$60 P Max

D
60 100 140 Quantity Bought and Sold

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 Indirect Effects Of Price Ceiling
• Inefficient Allocation to Consumers
– People who really want the good and are willing to pay a high price
don’t get it, and those who are not so interested in the good and are
only willing to pay a low price do get it.
• Example: rent control. In such case people get the apartment
usually through luck or personal connections.

• Wasted Resources
– People spend money, time and expend effort in order to deal with the
shortages caused by the price ceiling.

• Black Markets
– Bribes may be used to induce rental facilities.

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 Cont…
• Inefficiently Low Quality
– In case of rent controls, there is no incentive for landlords to improve
the conditions of the apartments.
– Reductions in service. When prices are held below market levels,
sellers have more customers than they need or want.

• The quantity exchanged will fall and the gains from trade will
be less than if the good were allocated by markets.

• Preferential treatment to selected customers

• Alternative pricing strategies

• The future supply of housing will decline.

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 Minimum Price Control/ Price
Floor
• A price floor is a legal minimum price that can be charged for
a good.

• A price floor establishes a minimum price that sellers are

legally permitted to charge.

• A price floor occurs when government sets a price for the

market that is above the equilibrium price.

• The most common example of a price floor is the minimum

wage, which is a floor set under the price of labour.

• The Direct effect is A surplus of labour: the quantity supplied

will exceed the quantity demanded.
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 Government Intervention In
Markets: Price Floor
Price Controls:
Price S Minimum Prices set
(wage) above normal equilibrium

$9 Min P
Assume
At theinitial
Minimum higher
Wage price,
Government
equilibrium
demand price
Legislation would =fall
in the $5
imposes
and amount minimum
bought
$5 Ghana
whereas theory and
– insupply
price
sold of $9 (Min P)
= 200
should
would rise
lead–toa
unemployment
surplus would but
in
exist.
reality?

D
170 200 240 Quantity of labour

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 Effects Of Price Floors
• The intervention by government to set the minimum wage
is likely to have these indirect effects on the market:

• Inefficient Allocation of workers Among firms / businesses

– Those who would be willing to sell the good at the lowest price are
not always those who actually manage to sell it. More labor supply
from teenagers: people in need may end up losing jobs.

• Inefficiently High Quality and Quantity

– Sellers (labour) offer high-quality goods at a high price, even though
buyers (firm/ business)would prefer a lower quality at a lower price.

• Less on-the-job training

• Reduction in non-wage component of compensation

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 Cont…
• Non-price elements of exchange
– Employers may discriminate certain types of job applicants.

• The price increase may encourage students to drop out of

school.

• Reduces employment of low-skilled labor.

– Those who lose their job would be pushed into either the
unemployment roles or some other less preferred form of
employment.

• The quantity exchanged will fall and the gains from trade will
be less than if the good were allocated by markets.

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