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Econ 101: Principles of Microeconomics

Chapter 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

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Consumer and Producer Surplus

Weve already talked about the notion of efficiency, noting that the
market usually lead to efficient outcomes (Principle #8).
Weve also noted that that there are gains from trade through
specialization (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 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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Consumer Surplus and the Demand Curve

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 consumers 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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Consumer Surplus and the Demand Curve

An Example: Josephs MWTP for Shoes

Suppose we know that Joseph has the following MWTP for shoes

Quantity Josephs MWTP


1 $120
2 $100
3 $80
4 $60
Notice that the MWTP declines as the quantity goes up.

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Consumer Surplus and the Demand Curve

Josephs MWTP Graphically


The MWTP generates Josephs demand curve.

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Consumer Surplus and the Demand Curve

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.
Josephs total consumer surplus is $30 + $10 = $40
Graphically, this total surplus is the area above the market price and
below the individuals demand curve.

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Consumer Surplus and the Demand Curve

Josephs Consumer Surplus Graphically

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Consumer Surplus and the Demand Curve

More than One Consumer

Suppose we now have several consumers in the market for shoes, with
MWTPs
Price Joseph Michael John Mary
1 120 110 90 85
2 100 70 65 75
3 80 30 40 65
4 60 0 15 25

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Consumer Surplus and the Demand Curve

Individual MWTP Graphs

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Consumer Surplus and the Demand Curve

The Market Demand for Shoes


The market will naturally organize itself from highest to lowest MWTP

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Consumer Surplus and the Demand Curve

What would be the Consumer Surplus with P=70?

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Consumer Surplus and the Demand Curve

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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Consumer Surplus and the Demand Curve

What Happens to CS if Price Falls?

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Producer Surplus and the Supply Curve

The Producer Side

Now lets look at that producers 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.
Dont forget that when we talk about costs, we are referring to the
opportunity cost.

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Producer Surplus and the Supply Curve

Consider a Single Producer of Shoes - Sam

Quantity Sams MC
1 $20
2 $40
3 $80
4 $100

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Producer Surplus and the Supply Curve

Sams Marginal Cost Curve


The MC generates Sams supply curve.

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Producer Surplus and the Supply Curve

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.
Sams total producer surplus is $40 + $30 = $70
Graphically, this total surplus is the area above the producers supply
curve and below the price.

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Producer Surplus and the Supply Curve

Sams Producer Surplus Graphically

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Producer Surplus and the Supply Curve

More than One Producer

Suppose we now have several producers in our shoe market, with MCs
Price Sam Annie Mark Cathy
1 20 40 25 50
2 40 80 50 60
3 80 120 75 70
4 100 160 100 80

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Producer Surplus and the Supply Curve

Individual MC Graphs

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Producer Surplus and the Supply Curve

The Market Supply for Shoes


The market will naturally organize itself from lowest to highest MC

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Producer Surplus and the Supply Curve

What would be the Producer Surplus with P=70?

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Producer Surplus and the Supply Curve

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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Producer Surplus and the Supply Curve

What Happens to PS if Price Rises?

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Total Surplus and the Gains from Trade

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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Total Surplus and the Gains from Trade

Graphically

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Total Surplus and the Gains from Trade

What Happens if...


...we artificially hold back production

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Total Surplus and the Gains from Trade

Efficiency and the Market


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

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Total Surplus and the Gains from Trade

The Efficient Market

The Efficient Market Performs Four Key Functions


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

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Total Surplus and the Gains from Trade

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.

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Total Surplus and the Gains from Trade

Government Intervention
As Krugman and Wells note in their Principle #9: When markets
dont achieve efficiency, government intervention can improve
societys welfare resulting from
1 poorly defined property rights;
2 inaccuracies of price as economic signals.
The authors note three key problem areas:
1 Market power
2 Externalities
3 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.

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