Econ 101: Principles of Microeconomics Chapter 4: Consumer and - - PDF document

Econ 101: Principles of Microeconomics

Chapter 4: Consumer and Producer Surplus Fall 2010

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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

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

• r 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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Consumer Surplus and the Demand Curve

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 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

• nly 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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Consumer Surplus and the Demand Curve

More than One Consumer

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

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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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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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What Happens to CS if Price Falls?

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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 price level,. . . but it also can be interpreted as indicating the marginal cost

• f 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

• pportunity cost.

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Consider a Single Producer of Shoes - Sam

Quantity Sam’s MC 1 $20 2 $40 3 $80 4 $100

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Producer Surplus and the Supply Curve

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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Producer Surplus and the Supply Curve

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 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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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

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

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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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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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 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

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

• f 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

• wning 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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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

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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