CONSUMER SURPLUS, PRODUCER SURPLUS, AND THE EFFICIENCY OF MARKETS

Overview

Two types of analysis:

1. Positive Analysis: Addresses what is -- uses theory and models to predict observable and testable tendencies in economic relationships

• Minimum Wage laws cause unemployment

• Price ceilings cause shortages

2. Normative Analysis: Addresses what should (or ought to) be -- depends on value judgments.

• The minimum wage should be higher

• Taxes should be lower

Overview

• Up to this point we have focused on positive analysis.

• Now we turn to normative analysis

• In other words we will examine how changes in prices and government intervention affect economic well-being and ask question such as: “What price is the “right” price in a market?”

• Answering such question falls under the umbrella of welfare economics.

• Welfare Economics: refers to how the allocation of resources affects economic well-being.

Overview

The main concepts of welfare economics are consumer and producer surplus.

• Consumer surplus measures economic welfare from the buyer’s side.

• Producer surplus measures economic welfare from the seller’s side.

Consumer Surplus

How much do consumers value a good or service?

Economists use the concept of willingness to pay to answer that question.

• Willingness to pay is the maximum amount that a buyer will pay for a good.

• Willingness-to-Pay (WTP) is closely related to Demand.

Willingness to Pay Schedule

Consumer

A

B

C

D

Willingness to Pay

$200

$140

$160

$100

Consider the willingness to pay of four individuals for airline tickets to Cancun for spring break

Demand Schedule

Price

More than 200

$160 - $200

$140 - $160

$120 - $140

$100 or less

Buyers

0

A

A + B

A + B + C

A + B + C +D

Quantity Demanded

0

1

2

3

4

Copyright©2003 Southwestern/Thomson Learning

Price

0 Quantity of Tickets

Demand

1 2 3 4

$200 A’s willingness to pay

160 B’s willingness to pay

140 C’s willingness to pay

100 D’s willingness to pay

“Step” Demand Curve

Consumer Surplus

CONSUMER SURPLUS: a measure of the benefits enjoyed by buyers in a market.

Consumer surplus = WTP – Price

Copyright©2003 Southwestern/Thomson Learning

Price

0Quantity of Tickets

Demand

1 2 3 4

Consumer Surplus

200

160

140

100

P = $180 Consumer Surplus = $20

P = $150 Consumer Surplus = $50 + $10 = $60

P = $100 Consumer Surplus =

$100 + $60 + 40= $200

Price

D

P1

Q1Quantity

P2

Q2

Consumer Surplus: Typical Demand CurveConsumer surplus at P1

(Area under Demand Curve, above Price)

Additional consumer surplus to existing customers

Additional consumer surplus to new customers

Producer Surplus

• Producer surplus is the amount a seller is paid for a good minus the seller’s cost.

– It measures the benefit to sellers participating in a market.

• Cost is minimum price a potential seller would accept for a good

– Cost is closely related to Supply

Cost Schedule

Firm

E

F

G

H

Cost

$50

$110

$220

$300

Consider the cost facing four airlines for flying a passenger to Cancun for spring break.

Supply Schedule

Price

Less than $50

$50 - $100

$110 - $200

$220 - $299

$300 or More

Sellers

0

E

E + F

E + F + G

E + F + G +H

Quantity Supplied

0

1

2

3

4

Price

0 Quantity1 2 3 4

“Step” Supply Curve

300

220

110

50 E’s Cost

F’s Cost

G’s Cost

H’s Cost

Producer Surplus

• PRODUCER SURPLUS: a measure of the benefits enjoyed by sellers in a market.

– Closely related to PROFIT

Producer Surplus = Price – Cost

Price

0 Quantity1 2 3 4

Producer Surplus

300

220

110

50

P = $80 Producer Surplus = $30

P = $150 Producer Surplus = $100 + $40 = $140

P = $250

Producer Surplus = $200 + $140 + $30= $370

P

S

P1

Q1 Q

P2

Q2

Producer Surplus: Typical Supply Curve

Producer surplus at P1 (Area above Supply Curve, below Price)

Additional producer surplus to existing suppliers

Additional producer surplus to new suppliers

Market Efficiency

• Consumer surplus and producer surplus may be used to address the following question:

– Is the allocation of resources determined by free markets in any way desirable?

• Consumer Surplus = Value to Buyers – Price Paid

• Producer Surplus = Price Received - Cost to Sellers

• Total Surplus = Consumer Surplus + Producer Surplus

Total surplus = Value to buyers – Cost to sellers

Market Efficiency

Efficiency is the property of a resource allocation of maximizing the total surplus received by all members of society.

– If an allocation of resources is efficient it is impossible to make anyone better off without making someone else worse off

Major Point:

The equilibrium in a competitive market maximizes the total welfare of buyers and sellers.

Consumer and Producer Surplus in Market EquilibriumPrice

QuantityQ1

P1

Supply

Demand

Consumer Surplus

Producer Surplus

Why Equilibrium is Efficient

Quantity

Price

0

Supply

Demand

Costto

sellers

Costto

sellers

Valueto

buyers

Valueto

buyers

Value to buyers is greaterthan cost to sellers.

Value to buyers is lessthan cost to sellers.

Equilibriumquantity

Quantity

Price

Demand

Supply

Q1

P1

Q2

D = loss in producer surplus from over production

Q3

A

B

D

C

A = loss in consumer surplus from under production.

Why Equilibrium is Efficient

B = loss in producer surplus from under production.

C = loss in consumer surplus from over production