Econ 101: Principles of Microeconomics - Chapter 4: Consumer and ...

Econ 101: Principles of Microeconomics Chapter 4: Consumer and Producer Surplus

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Ch. 4: Consumer and Producer Surplus

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Outline

1

Consumer Surplus and the Demand Curve

2

Producer Surplus and the Supply Curve

3

Total Surplus and the Gains from Trade

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Consumer and Producer Surplus We’ve already talked about the notion of efficiency, noting that the market usually lead to efficient outcomes (Principle #8). We’ve also noted that that there are gains from trade through specialization (Principle #5). Some natural questions we might ask are: 1 2

Is there a way to measure (i.e., quantify) the gains from trade? Similarly, when there are inefficiencies in the market (either intentional, as a means of achieving equity, or unintentional, due to market failure or intervention in the market), can we measure the corresponding loss?

In this chapter, we introduce the notions of consumer surplus and producer surplus to answer these questions.

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Marginal Willingness-to-Pay

The demand curve provides a graphical depiction of the quantity demanded of a good at various price levels. Another useful way of looking at the demand curve is as measuring the consumer’s marginal willingness-to-pay (or MWTP) for a good. The MWTP is the maximum price the individual would be willing to pay for the next unit of the good or service.

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An Example: Joseph’s MWTP for Shoes

Suppose we know that Joseph has the following MWTP for shoes Quantity Joseph’s MWTP 1 $120 2 $100 3 $80 4 $60 Notice that the MWTP declines as the quantity goes up.

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Joseph’s MWTP Graphically The MWTP generates Joseph’s demand curve.

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Consumer Surplus for the Individual

So, what is the net gain to Joseph if he buys 2 pairs of shoes at $90 per pair? Well, he would have been willing to pay $120 for the first pair, but only paid $90, for a net gain (or surplus) of $120 - $90 = $30. For the second pair, his surplus is smaller, since he is only WTP $100 for the second pair of shoes. In this case, the surplus is $100 - $90 = $10. Joseph’s total consumer surplus is $30 + $10 = $40 Graphically, this total surplus is the area above the market price and below the individual’s demand curve.

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Joseph’s Consumer Surplus Graphically

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More than One Consumer

Suppose we now have several consumers in the market for shoes, with MWTP’s Price 1 2 3 4

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Joseph 120 100 80 60

Michael 110 70 30 0

John 90 65 40 15


Mary 85 75 65 25

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Individual MWTP Graphs

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The Market Demand for Shoes The market will naturally organize itself from highest to lowest MWTP

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What would be the Consumer Surplus with P=70?

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Consumer Surplus In a large market, or in a market where quantities need not be integers, the demand curve is typically drawn as smooth Consumer surplus is still the area above the price and below the demand curve

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What Happens to CS if Price Falls?

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The Producer Side

Now let’s look at that producer’s side of the problem. The supply curve tells us the quantity supplied at each price level,. . . but it also can be interpreted as indicating the marginal cost of producing one more unit. The marginal cost will be the lowest price at which the producer would be willing to sell the next unit of the good or service. Don’t forget that when we talk about costs, we are referring to the opportunity cost.

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Consider a Single Producer of Shoes - Sam

Quantity 1 2 3 4

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Sam’s MC $20 $40 $80 $100



Sam’s Marginal Cost Curve The MC generates Sam’s supply curve.

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Producer Surplus for the Individual

So, what is the net gain to Sam if he sells 2 pairs of shoes at $70 per pair? Well, the first pair of shoes cost him $20 to produce, but he sold them for $70, for a net gain (or surplus) of $70 - $20 = $50. For the second pair, his surplus is smaller, since they cost him $40 to produce. In this case, the surplus is $70 - $40 = $30. Sam’s total producer surplus is $40 + $30 = $70 Graphically, this total surplus is the area above the producer’s supply curve and below the price.

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Sam’s Producer Surplus Graphically

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More than One Producer

Suppose we now have several producers in our shoe market, with MC’s Price 1 2 3 4

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Sam 20 40 80 100

Annie 40 80 120 160

Mark 25 50 75 100


Cathy 50 60 70 80

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Individual MC Graphs

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The Market Supply for Shoes The market will naturally organize itself from lowest to highest MC

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What would be the Producer Surplus with P=70?

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Producer Surplus In a large market, or in a market where quantities need not be integers, the supply curve is typically drawn as smooth Producer surplus is still the area above the supply curve and below the price

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What Happens to PS if Price Rises?

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Total Surplus and the Gains from Trade If we put both of these pieces together (i.e., supply and demand), we can see (and measure) the gains from trade. We saw in the last chapter that market forces will cause price to change until the quantity supplied just equals the quantity demanded. This equilibrium results in gains for both sides of the market - Consumers gain in the form of consumer surplus, with those buying paying less (or at least no more) than their MWTP for the goods they buy. - Producers gain in the form of producer surplus, with those selling receiving more (or at least no less) than their MC of production.

More impressive is the fact that this allocation is efficient. . . ; i.e., there is no way to move from this equilibrium that will make some people better off, without making other people worse off.

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Graphically

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What Happens if... ...we artificially hold back production

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Efficiency and the Market Any reallocation of buyers or sellers will reduce the overall surplus.

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The Efficient Market The Efficient Market Performs Four Key Functions 1

2

3

4

It allocates consumption of the good to the potential buyers who value it the most, It allocates sales to the potential sellers who most value the right to sell the good (i.e., those who have the lowest cost) It insures that every buyer values the good more than every seller who sells the good (i.e., there is a surplus from the trade) It insures that every consumer who doesn’t buy the good values it less than every seller who does not sell the good (i.e., there are no additional gains from trade).

There are several important caveats 1 2 3

Efficient markets are not necessarily equitable; Markets can fail While markets maximize total surplus, they do not maximize the surplus of individuals in the market;

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Keys to the Market Functioning Well There are two keys to the market functioning well 1 Property Rights; i.e., the rights of owners of valuable item to dispose of them as they choose. An example system would include Universality requires that all resources are privately owned and all entitlements completely specified, Exclusivity requires that all benefits and costs accrued as the result of owning and using the resources should accrue to the owner, and only the owner, either directly or indirectly by sale to others. Transferability requires that all property rights should be transferable from one owner to another in a voluntary exchange. Enforceability requires that property rights should be secure from seizure or encroachment by others 2

An Economic Signal; i.e., any piece of information that helps people make better economic decisions. Prices are the key signal in a market economy, but not always perfect. Herriges (ISU)


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Government Intervention As Krugman and Wells note in their Principle #9: “When markets don’t achieve efficiency, government intervention can improve society’s welfare” resulting from 1 2

poorly defined property rights; inaccuracies of price as economic signals.

The authors note three key problem areas: 1 2 3

Market power Externalities Goods (e.g., public goods, common property resources, etc.) that by their nature are unsuited to traditional markets or property right assignments.

While it is true that government intervention can improve welfare, it is not necessarily the case that they will improve welfare. Understanding the unintended consequences of market interventions is key to setting public policy. Herriges (ISU)


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