Welfare economics is the study of how the allocation of resources affects economic well-being. Participation in market leads to buyers receiving benefit consumer surplus and sellers receiving benefit producer surplus. Equilibrium maximises total welfare.
Willingness to pay measures the buyers’ value of a good or service as the maximum amount that a buyer will pay for a good. Consumer surplus is the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it. Every buyer has a different willingness to pay. The market demand curve depicts the various quantities that buyers would be willing and able to purchase at different prices. Consumer surplus, equals the amount buyers are willing to pay for a good minus the amount they actually pay for it. It measures the buyer’s perceived benefit from the good. It is measured as the area below the demand curve and above the price in the market. Represented in the demand schedule and the demand curve Price / Buyers / Quantity.
Producer surplus is the amount a seller is paid for a good minus its cost. It measures the benefit to sellers participating in a market. Producer surplus is closely related to the supply curve. The producer surplus equals the area below the price and above the supply curve. Represented in the supply schedule Price / Sellers / Quantity Supplied.
Consumer surplus = value to buyers – amount paid by buyers.
+ Producer surplus = amount received by sellers – cost of sellers.
= Total surplus = consumer surplus + producer surplus or value of buyers – cost of sellers.
Efficiency is when a resource allocation maximises the total surplus received by all members of society. Social planners (policymakers) might also care about equity the fairness of the distribution of wellbeing among the various buyers and sellers. Free markets allocate supply of goods to buyers who value them most highly. Valuation is measured by buyer’s willingness to pay. To allocate the demand for goods to the sellers who can produce them at least cost. Produce the quantity of goods that maximises the sum of consumer and producer surplus.
EQUILIBRIUM IN THE MARKET
The equilibrium outcome yields an efficient allocation of resources, social planners can opt to keep the market outcome. The equilibrium of demand and supply via the invisible hand of the market maximises the sum of consumer and producer surplus. This policy of leaving well enough alone goes by the French expression laissez-faire. If a market system is not perfectly competitive, market power may result. Market power is the ability to influence prices. Inefficiency results by shifting the price and quantity away from the equilibrium of supply and demand.
A market outcome that affects individuals outside buyers and sellers in that market creates an externality. Hence welfare in that markets isn’t just the value to the buyers and costs of the sellers. If buyers and sellers ignore externalities in their plans, an inefficient market equilibrium can result.