Policy & the Perfectly

Competitive Model: Consumer

& Producer Surplus
 Recall:
Consumer surplus is the difference between what the consumer
has to pay for a good and the amount he/she is willing to pay.
It is the area under the demand curve & above the price.

P
S

P*

D
Q* Q
 Producer surplus is the difference between what the
producer receives for the good and the amount he/she must
receive to be willing to provide the good.
It is the area above the supply curve & below the price.

P
S

P*

D
Q* Q
 Social Welfare

Social welfare = consumer surplus + producer surplus.

In cases where there is tax revenue involved, that is
added as well in the computation of social welfare.
 Lets look at the sizes of the consumer &
producer surpluses at various output levels.
At quantity Q1 & price P1, consumer surplus is the
purple area & producer surplus is the green area.

P
S
P1

Q1 Q
As we increase the quantity & reduce the price,
the total area of the consumer & producer
surpluses increases,
P
S
P2

Q2 Q
 and increases,

P
S

P3

D
Q3 Q
until we reach the perfectly competitive
equilibrium.

P
S

P*

D
Q* Q
We can not continue this process beyond that equilibrium
however.
Output levels greater than the equilibrium will only be
purchased at prices below the equilibrium price, but they
will only be produced at prices above the equilibrium price.
So there is no price at which those output levels will be
produced & sold.
P S
PS
PD

D
Q4 Q
 We have found that social welfare,
which equals
total consumer & producer surplus,
is maximized at the
perfectly competitive equilibrium.
Lets explore the welfare effects of
some government policies.
 Price Ceilings
Without the ceiling our consumer & producer
surpluses are as shown by the purple & green areas.
P
S

P*

D
Q* Q
With price ceiling, Pc , the consumer & producer
surpluses are as shown.

P
S

Pc

Qc Q
Consumers have lost area V but gained area U.

P
S

V
U
Pc

Qc Q
The consumers who gain are those who get the product
at a lower price.
The consumers who lose are those who are no longer
able to buy the product because there is less supplied.
P
S

V
U
Pc

Qc Q
In the graph shown, area U is larger than area V,
so consumers as a whole gain. However, if area
U is smaller than area V, consumers lose.
P
S

V
Pc U

Qc Q
Producers have lost areas U and W.

P
S

U W
Pc

Qc Q
So area U just moved from producers to consumers,
but areas V and W were lost to everyone.

P
S

V
U W
Pc

Qc Q
Area V+W is the difference in the total consumer and
producer surplus with and without the policy
(CS2 + PS2) (CS1 + PS1).
P
S

V It is the deadweight
W loss to society that
Pc results from the policy.

Qc Q
 Price Ceiling Example: Rent Controls
Suppose in the absence of controls, equilibrium rent would be
8 thousand dollars per year & equilibrium quantity would be
2 million apartments.
Rent
(thousands of
dollars per year) S

D
0 2.0 Quantity of
apartments
(millions)
 Next suppose that a price ceiling of 7 thousand dollars is
imposed. As a result the quantity supplied drops to 1.8 million.

Rent
(thousands of
dollars per year) S

8
7

D
0 1.8 2.0 Quantity of
apartments
(millions)
 Based on the graph, determine the effects
on consumers, producers, & society as a whole.

Rent
(thousands of
dollars per year) S
9
8
7

D
0 1.8 2.0 Quantity of
apartments
(millions)
 Recall that consumers gain area U and lose area V.
Producers lose areas U and W.

Rent
(thousands of
dollars per year) S
9
V
8 W
U
7

D
0 1.8 2.0 Quantity of
apartments
(millions)
 U = (1.8 million) (8,000 7,000) = $1,800 million
V = (1/2)(0.2 million)(1,000) = $100 million
W = (1/2)(0.2 million)(1,000) = $100 million

Rent
(thousands of
dollars per year) S
9
V
8 W
U
7

D
0 1.8 2.0 Quantity of
apartments
(millions)
 Consumers gain
U V = $1,800 million - $100 million = $1,700 million.
Producers lose
U + W = $1,800 million + $100 million = $1,900 million

Rent
(thousands of
dollars per year) S
9
V
8 W
U
7

D
0 1.8 2.0 Quantity of
apartments
(millions)
Producers lose $200 million dollars more than consumers gain.
So there is a deadweight loss of $200 million per year.

Rent
(thousands of
dollars per year) S
9
V
8 W
U
7

D
0 1.8 2.0 Quantity of
apartments
(millions)
 Are the effects of price floors
similar to those of price ceilings?
Lets see.
Once again without the floor, consumer & producer
surpluses are as shown by the purple & green areas.

P
S

P*

D
Q* Q
If a price floor of Pf is imposed, consumer & producer
surpluses are these purple & green areas.

P
S
Pf

Qf Q
Consumers lose areas U & V.

P
S
Pf
U V

Qf Q
Producers gain area U & lose area W.

P
S
Pf
U
W

Qf Q
Again the deadweight loss is area V+W .

P
S
Pf
V
W

Qf Q
 In the analysis that we just did,
we assumed that producers cut their output so that it
was just equal to Qf, the quantity demanded.

P
S
Pf

Qf Q
However, it doesnt always work that way.
In the case of agricultural price supports,
producers grow as much as they want
and the government buys the surplus.
At a price of Pf, producers will supply Qs.
The resulting surplus is Qs Qd, which is purchased by the
government with taxpayer money at price Pf.
This represents a cost to consumers of the gray rectangle T.
P
S
Pf
P*
T

Qd Qs Q
Consumer surplus also falls by area U + V.
So consumers lose a total of T + U + V .

P
S
Pf
U V
P*
T

Qd Qs Q
Remember that producer surplus is the area under the price
and above the supply curve.
So producer surplus increases from the orange area
to the yellow area.
P
S
Pf
P*

Qf Q
The increase in producer surplus is the pink area.

P
S
Pf
P*

Qf Q
That gain to producers is much smaller than
the loss to consumers (T + U + V).

P
S
Pf
U Therefore, as a
V
P* result of the price
floor, total social
T welfare falls.

Qd Qs Q