Lecture 6

Consumer’s and Producer’s Surplus

Required Text

Frank and Bernanke – Chapter 3

Market Equilibrium

Earlier, we saw that market equilibrium occurs when the quantity of a good offered by sellers at a given price equals the quantity buyers are willing and able to purchase at that same price.

That is, market equilibrium occurs at price equals P* and quantity equals Q*.

Q

P

D

S

Q*

P*

Measuring the Gains from Trade

Whenever an exchange (or trade) takes place between a consumer and a producer, both parties gain from that exchange (or trade)

The consumer’s gain from the trade is termed as The consumer’s surplus

The producer’s gain from the trade is termed as The producer’s surplus

The sum of the consumer’s and producer’s surplus is the total gains from a particular trade (or exchange).

The Consumer’s Surplus

The Consumer’s Surplus is defined as the

difference between what the consumer would be

willing to pay and what the consumer actually

pays to acquire a given quantity of a good.

In other words, the consumer’s surplus is the

amount by which the value of her purchases

exceeds what she actually pays for them

A Numerical Example

Price Quantity

Willing to Pay

Actual Paymen

t

Consumer

Surplus

15 1 15 15 0

13 2 28 26 2

10 3 38 30 8

7 4 45 28 17

5 5 50 25 25

2 6 52 12 40

1 7 53 7 46

The Consumer’s Surplus

Note that for buying Q1 units, consumer is willing to pay P1/unit of product.

For buying Q2 units, consumer is willing to pay P2/unit of product.

But at market equilibrium, the consumer buys Q3 units of the product for P3/unit of product.

Thus, at the equilibrium price of P3/unit of product, consumer actually ends up paying less than what he is willing to pay.

This difference is called the Consumer’s Surplus.

Q

P

D

S

Q3

P3

P2

P1

Q1 Q2

The Consumer’s Surplus

In general, the Consumer’s Surplus can then be calculated as the area under the demand curve and above the price level, i.e., the shaded area.

Q

P

D

S

Q

P

The Producer’s Surplus

The Producer’s Surplus is defined as the dollar amount by which a firm benefits by producing its profit maximizing level of output.

In other words, a Producer’s Surplus is the amount by which the producer’s revenue exceeds her variable production costs

Producers’ Surplus

Note that for selling Q1 units, producer is willing to accept P1/unit of product.

For selling Q2 units, producer is willing to accept P2/unit of product.

But at market equilibrium, the consumer sells Q3 units of the product at P3/unit of product.

Thus, at the equilibrium price of P3/unit of product, producer actually ends up receiving more than what he is willing to accept.

This difference is called the Producers’ Surplus.

Q

P

D

S

Q3

P3

Q1 Q2

P2

P1

The Producer’s Surplus

In general, Producers’ Surplus can then be calculated as the area above the supply curve and below the price level, i.e., the shaded area.

Q

P

D

S

Q1

P1

The Consumer’s and Producer’s Surpluses

The Consumer’s Surplus is given by the area under the demand curve and above the price level.

The Producer’s Surplus is given by the area above the supply curve and below the price level.

So the Total Surplus is the sum of the Producer’s Surplus and the Consumer’s Surplus

Q

P

D

S

Q1

P1

Consumer’s and Producer’s Surpluses A Mathematical Application

Suppose that the demand and supply function are given by QD = 40 – 2P QS = 2P

Market equilibrium occurs at the intersection of the demand and supply functions. Thus, at the market equilibrium QS = QD

Now, setting QS = QD , we have 40 – 2P = 2P => 4P = 40 => P* = 10 (equilibrium price)

Plugging the equilibrium price to either the demand or supply function QD = 40 – 2(10) => QD = 20 QD = 20 = QS (equilibrium quantity)

Consumer’s and Producer’s Surpluses A Mathematical Application

The consumer’s surplus is the area of the triangle between the price lineand demand curve For QD = 20, P = 10 (the equilibrium price and quantity exchanged) For QD = 0, P = 20 (this is the vertical intercept of the inverse demand

function) The vertical intercept above the price line is (20-10=) 10 The area of the triangle between the price line and the demand curve,

i.e., CS= (1/2)*20*10 = 100

The producer’s surplus is the area of the triangle between the price lineand supply curve For QS = 20, P = 10 (the equilibrium price and quantity exchanged) The vertical intercept above the price line is 10 The area of the triangle between the price line and the supply curve, i.e., PS= (1/2)*20*10 = 100

The total surplus, TS = CS + PS = 100+100 = 200

Total Economic Surplus or Social Surplus

Total Economic Surplus or Social Surplus: The sum of the surpluses from trade of a commodity or service to all participants (all consumers and producers)

Total economic surplus from all exchanges of a commodity occurred at a particular point in time can be calculated in the same way, using the aggregate (market) demand and supply functions (curves) Consumers’ surplus is the area of the triangle between the

equilibrium price line and the market demand curve Producers’ surplus is the area of the triangle between the

equilibrium price line and the market supply curve

Total Economic Surplus = Consumers’ Surplus +

Producers’ Surplus

The Effect of a Sales Tax

Deadweight Loss

Excise TaxImpacts on Consumers’ and Producers’ Surplus

An excise tax per unit of the commodity shifts the supply curve from S to S1.Resulting in a change in the equilibrium price from P1 to P2 and equilibrium quantity from Q1 to Q2.

Before tax CS = abP1

After tax CS = adP2

Tax decreased CS Before tax PS = cbP1

After tax PS = edP2

Tax decreased PS Before tax Total Surplus = abc

After tax Total Surplus = adeTax decreased Total Surplus

Society overall is worse off due to the excise tax

Q

P

D

S

Q1

P1

S1

a

b

c

P2

d

e

Q2

Increase in IncomeImpacts on Consumers’ and Producers’ Surplus

Increase in income shifts the demand curve from D to D1.Resulting in a change in the equilibrium price from P1 to P2 and equilibrium quantity from Q1 to Q2.

Initial CS = abP1

Later CS = edP2

Not sure if CS increased or decreased. Initial PS = cbP1

Later PS = cdP2

Increase in PS Initial Total Surplus = abc

Later Total Surplus = edcAn increase in Total Surplus

Society overall is better off due to an increase in consumer income.

Q

P

D

S

Q1

P1

a

b

c

D1

Q2

P2

d

e

Market Equilibrium: The Invisible Hand

Equilibrium Principle Markets communicate information effectively

Value buyers place on the product Opportunity cost of producing the product

When the market for a good is in equilibrium, the seller’s cost of producing an addition unit of the good is the same as the consumer’s benefit of having that additional unit

MC = MB When a market is not in equilibrium, it is possible to

identify mutually beneficial exchanges.

Equilibrium Principle: A market in equilibrium leaves no unexploited opportunities for individuals but may not exploit all gain achievable through collective action.

Economic Efficiency

Socially Optimal Quantity: The quantity of a good that results in the maximum possible economic surplus from producing and consuming the good.

Economic Efficiency: An economy is said to be efficient when all goods and services are produced and consumed at their respective socially optimal level

Is the market equilibrium quantity of a good efficient? Only when the seller pays the full cost of production and the

buyer captures the full benefit of the good MC = MB the equilibrium quantity maximizes social surplus −

socially optimal

Smart for One, Dumb for All

Producers sometimes shift costs to others Pollution is like getting free waste disposal services Total marginal cost = seller's marginal cost plus marginal

cost of pollution When costs are shifted, supply is greater than socially

optimal

Buyers may create benefits for others Marginal benefit is less than the full social benefit Vaccinations, my neighbor's landscaping The demand for these goods is less than socially optimal

Regulation, taxes and fines, or subsidies can move the market to optimal level

Efficiency Principle

Efficiency Principle: When the economic pie (social surplus) grows larger through efficiency, everyone can have a larger slice.