Market Equilibrium and Welfare Analysis for AP Economics (page 3)

By — McGraw-Hill Professional
Updated on Mar 2, 2011

Welfare Analysis

Main Topics: Total Welfare, Consumer Surplus, Producer Surplus

Total Welfare

The competitive market, free of government and externalities, produces an equilibrium outcome that provides the maximum amount of total welfare for society. Society consists of all consumers and all producers and, in the marketplace, each party seeks the other so that they can make an acceptable transaction at the going market price. Each party expects to gain in these transactions. Total welfare is the sum of two measures of these gains: consumer surplus and producer surplus.

Consumer Surplus: You know that great feeling you get when you pay a price that is lower than you expected, or is lower than you were willing to pay? That's consumer surplus, the difference between your willingness to pay and the price you actually pay. The market demand curve, at each quantity, measures, society's willingness to pay (the price). You can see consumer surplus in Figure 6.14. At a price of $5, three units of the good are purchased. The first two units receive some amount of consumer surplus because the willingness to pay exceeds $5. The consumer of the third unit pays a price exactly equal to his willingness to pay so he earns no consumer surplus. Total consumer surplus is the total amount earned by these three consumer transactions.

Producer Surplus: Producers are ecstatic when they receive a price for their product that is above the marginal cost of producing it. This is producer surplus, the difference between the price received and the marginal cost of producing the good. The market supply curve, at each quantity, measures society's marginal cost. You can see producer surplus in Figure 6.15. At a price of $5, three units of the good are produced. The first two units earn producer surplus because $5 is above the marginal cost. The third unit earns no additional producer surplus since the marginal cost is exactly equal to the price received. Total producer surplus is the total amount earned by these three producer transactions.

Welfare Analysis

  • The area under the demand curve and above the market price is equal to total consumer surplus.
  • Welfare Analysis

  • The area above the supply curve and below the market price is equal to total producer surplus.
  • Welfare Analysis

So, is market equilibrium conducive to increasing total welfare for society? Combining Figures 6.14 and 6.15 completes the market pictured in Figure 6.16. We see that the combined consumer and producer surplus, or total welfare, is greatest at the equilibrium price of $5 and quantity of three units.

At a lesser quantity (e.g., two units), the combined area is smaller than at a quantity of three. At greater quantities (i.e., q = 4) the price of $5 exceeds MB so consumer surplus is being lost. If this weren't bad enough, the MC exceeds the price at q = 4 so producer surplus is being lost. Thus, if total welfare is falling at quantities less than three and at quantities greater than three, total welfare must be maximized at the market equilibrium quantity of three and price of $5.

The review questions for this study guide can be found at:

Demand, Supply, Market Equilibrium, and Welfare Analysis Review Questions for AP Economics

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