Question

Using the concepts of WTP, WTA, Consumer surplus and producer surplus, explain how free markets maximize social welfare.

Answer 1

WTP (willingnes to pay) is the value of a good to a consumer. It is the amount of money that he is willing to pay for the good. If his WTP is higher than the price, he will buy the good. If his WTP is lower than the price , he will not buy the good. Consumer surplus is the difference between his WTP and equilibrium price. The higher the WTP, the higher is the consumer surplus.

Similarly, WTA (willingness to accept) is the lowest price the seller will accept to sell the good. The lower the WTA, the higher is the producer surplus. Produceer surplus is the difference between WTA and equilibrium price. Thus WTP and WTA are reservation price of the buyer and the seller respectively. The buyer with maximum WTP will be allocated the goods by producers who can produce them at the lowest cost. Thus the highest WTP and lowest WTA will interact to determine the market equilibrium. In a free market, the quantity of goods and the price will, thus, be at a point where social welfare is maximum.

In the graph above, only those whose WTP is higher than the prcie P will be able to buy, and only those sellers whose WTA is lower than the price P will be able to sell the good. Thus WTP and WTA are solely responsible for the social welfare in this market. Consumer surplus and producer surplus are maximum. Price and quanitty at equilibrium are the interaction between WTP and WTA where the consumer surplus and producer surplus are maximized. Thus, social welfare is maximum and there is no deadweight loss.