1

Willingness to Pay, MB and Consumer Surplus

2

The Demand curve again

1 2 3 4 5 Q

P

7

5

3

1.5

1

.5

Note the axes are not drawn to the same scale.

a

b g

c h l

d i m p

e j n q s

f k o r t

3

the demand curve again

Say the demand curve on the previous screen is for an individual. We saw in an earlier section that the individual attempts to maximize utility and adjusts how much of a good to take when the price changes because

1) with a price increase previously attainable baskets can no longer be attained and typically a lower quantity is demanded, and

2) with a price decrease more baskets can be obtained and typically a greater quantity is demanded.

4

Another way to see the demand curve

What is the amount the person is willing to pay for the first unit on the demand curve two screens ago? Since the first unit is not demanded until the price is 5, we say the person is willing to pay $5 for 1 unit of the good.

Note in the graph from before that the area made up of the part b, c, d, e, and f is the $5 the person is willing to pay for the first unit. Also note that $5 the person is willing to pay could have been used elsewhere and would generate utility in this other place.

5

Another way to see the demand curve

Since the $5 would be used here we say the utility here is more than in the other place. Since at $6 the person did not demand the unit, $6 is too much to represent the utility they get from the first unit.

In this example, $5 represents the utility the individual gets from the first unit.

Now, on the demand curve we see the person is willing to pay $3 for the second unit, but no more. $4 would be too much to represent the utility they get from the second unit.

6

total willingness to pay

In our example the person is willing to pay, in total, $5 for one unit, $8 for 2 units total, and $9.50 for 3 units.

How much is the person willing to pay for 4 and 5 units?

7

Marginal Benefit - MB

Since the individual is willing to pay $8 for 2 units and $5 for one unit we can say the individual is willing to pay $3 for the second unit. The $3 is the marginal benefit of the second unit and represents the utility the individual adds by having this second unit.

What is the marginal benefit of the first unit? Of the 3rd, 4th and 5th units?

The demand curve height at each quantity is the marginal benefit of that unit.

8

Demand again

1 2 3 4 5 Q

7

5

3

1.5

1

.5

a

b g

c h l

d i m p

e j n q s

f k o r t

P

9

Actual price

Say the actual price in our example is $1 (supply and demand meet in the market at $1.) (the $1 is what the person has to give up to get the unit - it is a cost to the consumer.) How much would the consumer buy?

The first unit would be bought because its marginal benefit is the equivalent of $5 and can be purchased for $1. ($5 always makes you happier than $1, right?) The second and third units would also be bought because the marginal benefits on those units are greater than $1 as well.

Even though the 4th unit has a MB = $1 we say the individual will buy it when the price is $1.

10

Price equals MB

Review: The demand curve shows us the marginal benefits of additional units.

Price is determined in the market.

People take units of a product up to the point where the price determined in the market is equal to the MB of the last unit.

In other words, take another unit if the MB > P, do not take a unit if the MB < P, and stop at the point where the MB = P on the unit.

11

P = MB

D = MB curve

P

market price

take stop don’t take

These units have more utility than the utility that could have been obtained elsewhere.

These units have less utility than the utility that could have been obtained elsewhere.

12

Market demand

The market demand curve is simply the summation, or addition, of the demand each person has in a market.

To get the market demand

1) look at each price

2) at each price add up what each person is willing to buy at that price.

The quantity demanded in the market is simply the quantities added up at each price across the people in the market

13

Consumer Surplus - CS

1 2 3 4 5 Q

7

5

3

1.5

1

.5

a

b g

c h l

d i m p

e j n q s

f k o r t

P I am using the same example I did before, but now think of this as the market demand curve.

14

CS

On the previous screen someone is willing to pay $5 for the first unit. Note areas b, c, d, e and f add up to the $5. This is almost all the area under the demand curve out to one unit. If we add in area a we can say all the area under the demand curve out to a quantity is what the consumer is willing to pay for the first unit. Of course area a should not be included, but it makes life easy to add it in.

So, the willingness to pay for any quantity is the area under the demand curve out to that quantity

15

CSP

S1

D1Q

P1

Q1

A

B

C

16

CS

On the previous screen the market price and quantity traded are P1 and Q1, respectively.

Consumer surplus is defined as what consumers are willing to pay for a product minus what they have to pay.

At the market equilibrium of Q1 units

consumers are willing to pay A + B + C, and

consumers have to pay B + C (really P1 times Q1), so

consumer surplus is A

17

CS

Consumer surplus is a triangle in this example. The area of a triangle is one-half of the base times the height. Let’s see an example:

16

7 10

area = .5(10)(16-7)

18

CS

Consumer surplus represents the utility consumers get from the products they buy over and above the utility they would have gotten had they bought something else.

I like to also think of the consumer surplus as money the consumer has left over after buying the units. They would have paid these dollars for the units, but did not have to. So these dollars can be used somewhere else. So, if you can buy goods that you want and pay less than you are willing to pay, then you not only benefit from having the goods you benefit from the mechanism by which you buy the goods.

The consumer surplus from one item can be used elsewhere.