Econ 101: Principles of Microeconomics - Chapter 4 ... · PDF fileEcon 101: Principles of...

Econ 101: Principles of MicroeconomicsChapter 4: Consumer and Producer Surplus

Fall 2010

Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 1 / 32

Outline

1 Consumer Surplus and the Demand Curve

2 Producer Surplus and the Supply Curve

3 Total Surplus and the Gains from Trade


Consumer and Producer Surplus

We’ve already talked about the notion of efficiency, noting that themarket usually lead to efficient outcomes (Principle #8).

We’ve also noted that that there are gains from trade throughspecialization (Principle #5).

Some natural questions we might ask are:1 Is there a way to measure (i.e., quantify) the gains from trade?2 Similarly, when there are inefficiencies in the market (either intentional,

as a means of achieving equity, or unintentional, due to market failureor intervention in the market), can we measure the corresponding loss?

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


Consumer Surplus and the Demand Curve

Marginal Willingness-to-Pay

The demand curve provides a graphical depiction of the quantitydemanded of a good at various price levels.

Another useful way of looking at the demand curve is as measuringthe consumer’s marginal willingness-to-pay (or MWTP) for a good.

The MWTP is the maximum price the individual would be willing topay for the next unit of the good or service.



An Example: Joseph’s MWTP for Shoes

Suppose we know that Joseph has the following MWTP for shoes

Quantity Joseph’s MWTP1 $1202 $1003 $804 $60

Notice that the MWTP declines as the quantity goes up.



Joseph’s MWTP GraphicallyThe MWTP generates Joseph’s demand curve.



Consumer Surplus for the Individual

So, what is the net gain to Joseph if he buys 2 pairs of shoes at $90per pair?

Well, he would have been willing to pay $120 for the first pair, butonly 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 $100for 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 andbelow the individual’s demand curve.



Joseph’s Consumer Surplus Graphically



More than One Consumer

Suppose we now have several consumers in the market for shoes, withMWTP’s

Price Joseph Michael John Mary1 120 110 90 852 100 70 65 753 80 30 40 654 60 0 15 25



Individual MWTP Graphs



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



What would be the Consumer Surplus with P=70?



Consumer SurplusIn a large market, or in a market where quantities need not beintegers, the demand curve is typically drawn as smoothConsumer surplus is still the area above the price and below thedemand curve



What Happens to CS if Price Falls?


Producer Surplus and the Supply Curve

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 pricelevel,. . . but it also can be interpreted as indicating the marginal costof producing one more unit.

The marginal cost will be the lowest price at which the producerwould 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 theopportunity cost.



Consider a Single Producer of Shoes - Sam

Quantity Sam’s MC1 $202 $403 $804 $100



Sam’s Marginal Cost CurveThe MC generates Sam’s supply curve.



Producer Surplus for the Individual

So, what is the net gain to Sam if he sells 2 pairs of shoes at $70 perpair?

Well, the first pair of shoes cost him $20 to produce, but he soldthem 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 toproduce.

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 supplycurve and below the price.



Sam’s Producer Surplus Graphically



More than One Producer

Suppose we now have several producers in our shoe market, with MC’s

Price Sam Annie Mark Cathy1 20 40 25 502 40 80 50 603 80 120 75 704 100 160 100 80



Individual MC Graphs



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



What would be the Producer Surplus with P=70?



Producer SurplusIn a large market, or in a market where quantities need not beintegers, the supply curve is typically drawn as smoothProducer surplus is still the area above the supply curve and belowthe price



What Happens to PS if Price Rises?


Total Surplus and the Gains from Trade


If we put both of these pieces together (i.e., supply and demand), wecan see (and measure) the gains from trade.

We saw in the last chapter that market forces will cause price tochange 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 buyingpaying less (or at least no more) than their MWTP for the goods theybuy.

- Producers gain in the form of producer surplus, with those sellingreceiving 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 somepeople better off, without making other people worse off.



Graphically



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



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



The Efficient Market

The Efficient Market Performs Four Key Functions1 It allocates consumption of the good to the potential buyers who value

it the most,2 It allocates sales to the potential sellers who most value the right to

sell the good (i.e., those who have the lowest cost)3 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)4 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 noadditional gains from trade).

There are several important caveats1 Efficient markets are not necessarily equitable;2 Markets can fail3 While markets maximize total surplus, they do not maximize the

surplus of individuals in the market;



Keys to the Market Functioning Well

There are two keys to the market functioning well1 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 allentitlements completely specified,Exclusivity requires that all benefits and costs accrued as the result ofowning and using the resources should accrue to the owner, and onlythe owner, either directly or indirectly by sale to others.Transferability requires that all property rights should be transferablefrom one owner to another in a voluntary exchange.Enforceability requires that property rights should be secure fromseizure or encroachment by others

2 An Economic Signal; i.e., any piece of information that helps peoplemake better economic decisions.Prices are the key signal in a market economy, but not always perfect.



Government Intervention

As Krugman and Wells note in their Principle #9: “When marketsdon’t achieve efficiency, government intervention can improvesociety’s welfare” resulting from

1 poorly defined property rights;2 inaccuracies of price as economic signals.

The authors note three key problem areas:1 Market power2 Externalities3 Goods (e.g., public goods, common property resources, etc.) that by

their nature are unsuited to traditional markets or property rightassignments.

While it is true that government intervention can improve welfare, itis not necessarily the case that they will improve welfare.

Understanding the unintended consequences of market interventionsis key to setting public policy.


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