Foundation of Welfare Economics

This article discusses the foundation of welfare economics, including market equilibrium, consumer surplus, producer surplus, stability conditions, and government policies in agricultural markets. It explains the concepts of consumer surplus and producer surplus, as well as the Walrasian and Marshallian stability conditions for market equilibrium. It also explores the impact of government policies, such as price ceilings, on market outcomes and social welfare. The effectiveness of government policies in agricultural markets is also analyzed.

Running head: FOUNDATION OF WELFARE ECONOMICS
Foundation of Welfare Economics
Name of the Student:
Name of the University:
Author Note:

1FOUNDATION OF WELFARE ECONOMICS
Introduction:
A market is place where two or more parties comes together for an economic
transaction. Consumer and producers are the important market players. Consumers
always try to maximise their utility at a minimum price and the producers always try
to maximise their profit by selling less amount of quantity at higher price.in other
way, it can be said that they try to gain more consumer surplus and the producer
surplus. Both the consumers and producers are better off when the market is in
equilibrium. Equality of demand and supply of a product causes the market
equilibrium. At equilibrium, producer surplus and consumer surplus is at optimum
level simultaneously. Market equilibrium is affected by the change in demand and
supply of product due behavioural decision of consumer and producers. The stability
and instability of market equilibrium depends on the output level of producer, market
price and the demand of the product simultaneously. There are two important and
most commonly used condition for the stability of market equilibrium. The conditions
are Walrasian Stability Condition and Marshallian Stability Condition. In the
discussion below, an application of these principles is described. Apart from these,
the effectiveness of government policy is discussed which has an impact on these
principles and tries to control the agricultural market.
Discussion:
Consumer surplus: Consumer surplus is defined as the difference between the
amount of money which is needed to buy a certain quantity of goods and the amount
of money consumer is willing to pay for that good. It is a part of social welfare ( Guo,
Koch and Zhu, 2017). The area below the demand curve and above price indicates
the consumer surplus.

2FOUNDATION OF WELFARE ECONOMICS
Price
QuantityO
Supply
Demand
EP
Q
Figure 1: Consumer surplus
The above figure presents a demand and supply curve intersecting each other
at point E. E is the equilibrium point where the equilibrium price P and equilibrium
quantity Q exists. The shaded area presents the consumer surplus.
Producer Surplus: Producer surplus is the difference between the amount received
by selling a product and the amount at which producer is willing to sell. It is also a
part of social welfare (Social Welfare= Consumer Surplus + Producer Surplus)
(Zhang et al. 2016). The area above supply curve and below price is the producer
surplus.

3FOUNDATION OF WELFARE ECONOMICS
Price
QuantityO
Supply
Demand
EP
Q
Figure 2: Producer Surplus
The above figure shows the producer surplus that is presented by a shaded
area.
Walrasian Stability Condition: The stability condition is based on the behavioural
assumption that the buyers will raise their bids if excess demand is positive and the
seller will lower the price if excess demand is negative (Hands, 2016). On the basis
of these assumption, the market will be stable if excess demand rise as the price of
the good rises.
Marshallian Stability Condition: The stability condition is based on the behavioural
assumptions that the seller will raise their output when the buyers offer a higher price
than the price that seller was charging (Yoshii, 2017). Then the seller will reduce the
output when the buyer offer a lower price than the price that seller was charging. On
the basis of this assumption, the market will be stable if there exist an inverse
relation between price and quantity demand.

4FOUNDATION OF WELFARE ECONOMICS
Price
QuantityO
Supply
Demand
EP
Q
Price
QuantityO
Supply
Demand
E
P
Q
Stable and Unstable: Market equilibrium is defined depending on the price and
quantity in a market. If the price and quantity demand is equal to the quantity supply
then the market is stable otherwise market is unstable (Figueira-de-Lemos, and
Hadjikhani, 2014). It can be explained by a graphical representation.
Figure 3: Stable Market Figure 4: Unstable Market
The above two figures presents stable and unstable market. In the stable
market equilibrium is at point E where quantity is equals to demand and price and
quantity is in equilibrium. In the unstable market, the price and quantity should be at

5FOUNDATION OF WELFARE ECONOMICS
equilibrium point but they are not there. Price P and quantity Q shows that there exist
an excess demand which makes the market unstable.
Adjustment process in Auctioneer’s Model of markets: The market always tries
to arrive at equilibrium price. There are several types of auctions which can lead the
market to the equilibrium and disequilibrium. There are two types of auctions
depending on the value of auction item to the bidder. These are common value
auction and private value auction (Friedman, 2018). There are four types of auctions
according to the mechanism to derive the price and the ultimate buyer. These are
ascending price auction (English auction), the first price sealed bid auction, the
second price sealed bid price auction (Vickery auction) and the descending price
(Dutch auction) (Friedman, 2018). In common value auctions, there is a common
value of items which is only revealed after the settlement of the auction. Now the
optimistic bidders overestimate the value of the item and pay a higher amount than
the true value. This is called winner’s curse (Branigan, Muckley and Ryan, 2018).
This reduces the consumer surplus for the buyer of the item and the seller gains the
producers surplus. In private value auctions, each bidder has set a value of the item
and the values differ across bidders. Descending price or Dutch auction starts with a
higher price that is so high that cannot be a bid by the buyers, asked by the
auctioneers. Then the auctioneers start to reduce the price until there is a willing
buyer (Mridha, and Bhattacharyya, 2017). Dutch auction is always about maximizing
producer’s surplus where buyers may lose the consumer surplus. First price sealed
bid auction also creates the winner’s curse situation as the item goes to the highest
bidder and the bids kept in an envelope are opened simultaneously which gives no
chance to estimate the highest bid (Wang, and Guo, 2017). Second price sealed bid
auction is settled to the highest bidder at the second highest bid price which leads

6FOUNDATION OF WELFARE ECONOMICS
the bidder to pay the true value for the item in the private auction. This often results
in the maximum surplus that means there is equilibrium price. In auctions, there is a
fixed supply and the bidders have their own demand. According to the demand
bidders raise the prices for the item. There is an increase in demand due to
increment in the price by the bidders which is nothing but the Walrasian stability
condition for the market. However as the supply of output is fixed Marshallian
stability condition is not applicable here. Moreover, the producer surplus is getting
higher as well as a deadweight loss arises as the bidder increases the price (Fisher,
2016).
An Example of Analysing Market Outcomes: Price ceilings is a government
intervention to control the market by imposing policies. Price ceiling is a maximum
legal price. Combination of these two functions indicates that the actual market price
can be below but not above a ceiling price. Example of price ceiling is wage and
price controls on a wide variety of goods to curb inflationary pressure. The effective
price ceiling force the market to move from equilibrium (Han and Strange, 2016). The
below graph presents the normal, free-market equilibrium at price PEand quantityQE.
So P1is the effective ceiling price. However, a price above equilibrium price, P2can
also allow the market to be in equilibrium. The market can attain the higher
equilibrium price at PE, but the ceiling price will not allow. There three possible
outcomes, A. market will not make any change or B. price of good will fall and
shortage will rise or C. price of the good will rise. Now these outcomes depend on
the enforcement of the ceiling price otherwise, market will attain the equilibrium
again (Foster and Burtraw, 2018). Say, the enforced ceiling price is equal to the price
P1as shown in the below diagram, then the result will be rise of an excess demand in
the market with Q2amount of demand and Q1amount of supply.

7FOUNDATION OF WELFARE ECONOMICS
Price
Quantity
Demand
Supply
Figure 5: Unstable Equilibrium in Case of Price Ceiling
The situation on other side where ceiling price is not enforced, has two
possible outcomes. A. the extra money which is paid in excess of ceiling price for
product, goes to the producer that means the firms or the producers are receiving a
higher amount. Hence, the firm will raise the output and attain the equilibrium as
stated in Marshallian stability condition of equilibrium. B. the extra money goes to the
third party rather than the producer which helps the producers to get rid of from the
enforced ceiling price. This creates the black market (Zhang, Ralescu, and Liu
2016). As the producers are not getting the extra money they do not produce extra
output. Say, they produce at Q1 and the ceiling price is P1. Now the black marketers
buy the product from the producers at price P1and sell it to the consumer at price P2
which comes from the demand curve. Hence, quantity demand and supply is same
as consumer and thee producer face different price and thus the market is in
equilibrium. Normally price ceiling is imposed for the welfare improvement of
consumer (consumer surplus) in the market (Fabrizi et al. 2016). The outcomes from

8FOUNDATION OF WELFARE ECONOMICS
the above discussion is not good. Enforced ceiling price reduces the price in the
market. An excess demand rises and makes the consumers unable to buy goods at
lower price due to the presence of shortage which is equal to the excess demand.
But the consumers will be better off, those who can buy at low price and the other
consumers will be worse off, those who cannot buy. Again when the ceiling price is
not enforced and the money goes to the black marketers. The extra money paid by
the consumers goes to the black marketers shows that the market is not controlled
by the regulation (Coyne and Coyne 2015). This results in not giving advantage of
the price ceiling to the consumers. Actually, consumers may get more disadvantage
by avoiding enforcement as it is relatively costly too them. So, there is no possibility
of a consumer advantage. The government may waste the resource in order to
attempt an enforcement of the regulation. So, there is no possibility of substantial
costs. In case of, no enforcement of ceiling price and a formation of black market
leads the consumers to pay a higher amount of price and also buy a lower amount of
quantity. Therefore, the consumers are worse off due to price ceiling in both the
cases.
Effectiveness of Government Policy for Agricultural Markets: Effect of
agricultural policies on the social welfare and welfare of individuals within the
economy is evolving through the partial equilibrium and general equilibrium analysis
approach (Pigou, 2017). If partial equilibrium approach is chosen to operate, then the
other markets are considered as the relative market and each market is isolated from
other markets. In this approach, price and quantity at individual market is determined
by the supply and demand of the market taking ceteris paribus condition for the
remaining markets (Vogel, 2018). This approach is beneficial when applied in the
condition where change in market price cannot fluctuate the price at other markets. If

9FOUNDATION OF WELFARE ECONOMICS
general equilibrium approach is chosen to operate in the market, then some
problems arise which is demand driven where the supply is taken as an
endogenous. The endogenous supply is only convenient when there is an impact off
aggregate production or expenditure by agricultural policies. So the application of
partial equilibrium analysis is a beneficial form of policy instruments evaluation.
Partial equilibrium proves that the benefit of fall in price due to shift in supply which is
higher than a loss due to the equal rise in price. Again, producers are earning on low
level price fluctuation due to change in demand and producers loss on stable price.
Total welfare is effectively positive if there is small price fluctuation due to
coincidental shifts in supply and demand. The results are shown in the below graph.

10FOUNDATION OF WELFARE ECONOMICS
Price
QuantityO
Demand
E
P
Q
G
F
D
C
BA
Price
QuantityO
Supply
E
P
Q
C
D F
B G
A
Figure 6: Price Stabilization under Supply Change. Figure 7: Price stabilization under Demand Change.
In figure 6 consumers are facing two prices P1and P2 at same probability. The
consumer surplus at price P1 and P2isP1 BG and P2 EGrespectively (). Hence the
expected consumer surplus is equal to P2 EG +0.5 P1 BE P2 (Harrison and Ng 2016). If
the price is stable then the consumer surplus at P is equal toPDG. It is clear that
P2 EG +0.5 P1 BE P2 > PDG and welfare loss is equal to 0.5 ( P1 BDP−PDE P2 ) >0. In figure
7, producer face two different prices P1 and P2with same probability. Now the

11FOUNDATION OF WELFARE ECONOMICS
producer surplus at price P1and P2is AE P1and P2 FB. Then the expected producer
surplus is A P1 E+0.5 P1 EF P2. The producer surplus at price P is ABP. The reduced
welfare is equal to0.5 ( PBF P2−P1 EBP ) >0.
Conclusion:
The above discussion is simply about the function of market and how it attains
the stable and unstable equilibrium. First the discussion was about the basic
principles of stability of market. Marshallian Stability Condition and Walrasian
Stability Condition deal with the supply and demand respectively depending on the
price change in the market. Before this conditions, there is a concept of consumer
surplus and producer surplus which is also incorporated in the equilibrium conditions.
Consumer surplus is the gain of consumer by purchasing a good at a lower price
than the willingness of consumer to pay for that good. Producer surplus is the gain of
the producer by selling at a higher price than the actual price of that good. The
optimum level of PS and CS simultaneously exist at the equilibrium price. In
auctioneer market, there exist a higher amount of producer surplus and a very low
amount of consumer surplus. Even some times there is negative consumer surplus
and the situation is known as winners’ curse. There is a fixed supply of product for
which auctioneer cannot increase the output as the price rises. But the bid rises due
to the positive excess demand. Simply, Marshallian Condition is unable to operate in
the auctioneer market. In case of price ceiling, by enforcement, is unable to increase
the consumer surplus as a whole because not all the consumers are getting the
good at that low price. So, eventually the costs to the government is getting wasted.
In other way, price ceiling, without enforcement, is also unable to solve the problem
as there is a black marketer who sales the good to the consumer at higher price
which reduces the consumer surplus and buying the good at low price from the

12FOUNDATION OF WELFARE ECONOMICS
producer which reduces the producers surplus. Acting as an agent between seller
and buyer it gains the extra price which is not improving the welfare. In agricultural
market, government policy is effective when the market is experiencing the price
fluctuation. Stable price reduces the expected welfare. Whereas the fluctuating price
is better for the social welfare where price is changing depending upon the demand
and supply for producer and consumer respectively (Gong et al. 2016).

13FOUNDATION OF WELFARE ECONOMICS
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