Earlier, we established an equilibrium in a perfectly competitive market. We had really two conditions; short run equilibrium and long-run equilibrium. Worked it out, even showed a little analysis of what would happen if something came along and tweaked, opening external shock in that case it was an example about some news that caused the demand curve to get stronger. What was the impact in the short run and long run as we traced it through from one equilibrium to a new equilibrium? That's really the job of analysts to figure out what happens, when shocks like this hit the market. It's also the job of analysts to figure out how to evaluate this outcome. So, in this lesson, we're going to think about evaluating market outcomes and it requires us to build a tool, a yardstick, a metric that we're going to use to see if we can figure out what about this equilibrium makes sense and what doesn't. So, I'm going to start by saying that our goal here is to understand the process of evaluating market equilibrium. So our goal, is to build this yardstick. We're going build a metric to measure efficiency. Now, the good news is that, once we built this metric, we're going to build it with the idea that it's good in all cases. So it's going to allow us to measure, not only what happened in our perfectly competitive model but we can use that same yardstick to evaluate what happens under monopoly and oligopoly and things like cartels and then oversight sorts of interesting problems that economists call market failures for we will look at those. Moving on later parts of this course over we're going to think about externalities which are damaging to society, damaging to other consumers. How does the metric hold up in measuring those? That's part of what we're going to do. So, we're going to start with an assumption. To start: we're going to say, initially we're going to assume no government intervention. we'll modify that pretty quickly because of course the government does intervene a lot. But to begin with, we'll start without them means that the implication is there's just two agents in the market, buyers and sellers. We want to figure out a metric to what does this market outcome actually contribute to the overall efficiency or happiness or welfare for consumers? This type of analysis, you would look in an economics textbook is often referred to as welfare economics. It's a way to try to build a measuring stick that a platform that will allow us to make some relative comparisons. So we'll start by thinking about consumers, and we're going to think about consumers by building a term called consumer surplus which from now on I'm just going to call consumer surplus.The definition of consumer surplus is, it's the excess of consumer value, net of consumer expenditures. So the way to think about this is, suppose they told you that in your brain you're calculating the value of that Diet Pepsi you're about to purchase and in your head you have an idea of what the true value of that Diet Pepsi is and you know all sorts of intrinsic characteristics about how it's going to make you feel. You also know how many of those little green sheets of paper you're going to have to part, so you have an idea about how much it's going to cost you the value to you above and beyond what you actually have to give up in terms of green sheets of paper embodying other things. That's what consumer surplus is all about. So, if in your head you think, ''Pepsi is going to be worth about $2.25 to me?'' You can get it for a dollar. Well, that means a $1.25 to the good, that would be consumer surplus. Now if it turns out that you have to pay $2.25 for it, and the value is $2.25. Well, that's a transaction's a wash. Having that Pepsi gives you $2.25 but you're giving up $2.25 worth of something else. So, you couldn't use it on something else and not know the difference. That's what it means. Of course finally, if its value to you is worth $2.25 and the market wants $2.50. Well, you're just not going to buy it. Because you're giving up $2.50 worth of embodied happiness in those green sheets of paper to get something that's only worth $2.25. So this is a pretty straightforward metric of what you the consumer, are getting out of this market. So let's think about this as we do, over and over again by drawing a graph. This is the demand curve. The demand curve represents a collection of people and their willingness to pay. Remember, at this price the demand curve tells us, this amount will be consumed. There's a consumer standing right here. This consumer has marginal value for this product. Suppose this is a can of Diet Pepsi. This consumer has marginal value for this can of Diet Pepsi of let's say $3.50. The price in a market is a $1.50. Now the consumers are not going to reveal, ''Hey, I paid $3.54,'' but in their head, they know that. We know this as analysts because we have been constructing this demand curve and using it over and over again as price floats up, fewer people will want to buy it. See it's price flows up, the markets getting smaller and smaller because more and more people say, ''It's just not worth it. I'm not going to give up all these green sheets of paper. Okay, there's other things I can buy.'' This person is still buying them because at this price $3.20, $3.50, still gives them a net transaction. They're giving up, make the mistake they'd love to have it for free. But that's not the way the markets working. The way you constructed this demand curve, you know if it's a continuous function which it isn't as graph, that there are people all along here and those people have marginal willingness to pay as represented by this curve. So for this particular transaction, this individual will get $3.50 worth of happiness for that Diet Pepsi. But they paid a $1.50 which means that their surplus, would just be this vertical gap. Remember what the definition said, it's the excess of consumer value, net of consumer expenditures. For this particular product, the consumer gets $3.50 but has to part with $1.50 worth of alternative enjoyment. So the net, that is the surplus for that particular transaction is $2. Now, the cool thing is, as long as you've constructed this curve, you know you've got the data from the people in IT at your company and you're able to tease out what the demand curve looks like by having different possible prices and seeing how people leave the market or enter of the market. You know that there are people all over the place. This person down here has value lower than a buck 50 doesn't even buy. But there are people here, because it's a continuous function, who actually have value like a buck 55. They're going to buy it. Their consumer surplus is not very much. But enough of pushing this you begin to see that as I add up all of these across here, the consumer surplus is the area of this triangle. So formally for us, we say consumer surplus is the area below demand and above price. If you have confidence in your demand curve, if you had done a good job of estimating your demand curve, you know there's a continuous stream of people who are going to leave the market as price gets higher and higher. But for the current price, there's a whole bunch of people who say that's good. I'm making a little net. There's a person over here who says, ''You don't want I'm even make it a higher net, I'm even making a higher net.'' We add all those up. We have something called consumer surplus. So, let's look at it one more time in a cleaner picture. If this is the supply curve, we know the market clearing price will be P0. You, the Pepsi consumer, you're not sure how that market actually happens but you know when you walk up to the place to buy the Pepsi it says a buck 50 and that's the market price. If you're willing to buy it, somewhere the little stick figure representing you is up here to the northwest of the equilibrium point. But we know there's lots of people along this curve and every one of these people are having some net above what they have to pay to get this product. This area, is called Consumer Surplus. Very powerful tool for us. I'm not kidding you hear, it's used every day in Washington DC. When people promulgate regulations, they have to talk about cost benefit analysis. So if they say well, ''I think it's a great idea that we have side airbags.'' We need to put that law in and they say, ''Well side air bags is certainly going to have a benefit.'' The benefit of the people will calculate the reduced injury factor. They'll calculate all this on net that we're going to see his society. But it's also going to raise the price of the car. When I raise the price of the car from let's say P0, wherever that was to the new price P1, besides that triangle has shrunk. This whole trapezoid is now missing. It's not there anymore. Because all of these consumers who were standing here, no longer purchased the product. They're gone. So this new smaller triangle, is the new consumer surplus and you can see it's clearly less than what the original triangle was. That's how these types of calculations are made every day because when regulators are required to produce cost-benefit analysis, they have to have some indicator. What's the pain and suffering to consumers or the higher price of this car. Now because we're putting more regulations on it. They actually calculate these little triangles.
