Using the concepts of WTP, WTA, Consumer Surplus, and Producer Surplus, explain how free markets maximize...

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

Expert Solution

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.

Similarly, WTA (willingness to accept) is the lowest price the seller will accept to sell the good. Thus WTP and WTA are reservation price of the buyer and 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. Thus, social welfare is maximum as there is no deadweight loss.

Price Supply Consumer surplus P Producer surplus Demand Q Quantity

Rahul Sunny answered 7 months ago

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