Eco 300 Intermediate Micro - University at Albany, SUNYaj4575/eco300_2010/LectureNotes/... ·...

Eco 300 Intermediate Micro

Instructor: Amalia Jerison

Office Hours: T 12:00-1:00, Th 12:00-1:00,and by appointment

BA 127A, [email protected]

A. Jerison (BA 127A) Eco 300 Spring 2010 1 / 24

Chapter 9

Consumer and producer surplus

This chapter studies the welfare effects of government policies:Who gains and who loses from a policy.

Consumer and producer surplus are used to show efficiency of acompetitive market.


Consumer surplus is the total benefit that consumers get frombuying a good beyond what they paid for it.

This equals the sum of the net benefits of each buyer.

In a graph, consumer surplus is the area between demand andprice.


Producer surplus is the sum of the differences between the priceand the marginal cost for each unit of the good sold.

In a graph, producer surplus is the area between the supply curveand the price.

Producer surplus is also equal to variable profit. This is profitplus fixed costs.


S

D

P

Quantity

Consumer surplus

Producer surplus


Consumer surplus

Producer surplus

quantity

Price

D

S


We can measure the change in welfare of consumers andproducers due to government intervention using consumer andproducer surplus.

Consider a binding price ceiling. The government makes it illegalfor sellers to charge more than a certain price for their output.

Due to a price ceiling there is excess demand. Buyers are willingto buy more of the good than sellers are willing to sell.


Some consumers – those that get the good at the lower thanequilibrium price – are better off due to the price ceiling.

Other consumers – those that would have bought the good at thehigher equilibrium price, but don’t get to buy the good – areworse off.

Producers are worse off due to the lower price.


D

S

P0

Pmax

Q1 Q0 Q2

Deadweight loss

Gain toconsumers

quantity

price


Deadweight loss is the difference in total surplus (the sum ofproducer and consumer surplus) due to the policy.

Here deadweight loss is total surplus when there is no price ceilingminus total surplus when there is a price ceiling.

The way it is drawn, consumer surplus has increased due to theprice ceiling. But total surplus has decreased.

We are assuming that the consumers that get to buy the good arethose who value it most highly. If rationing were random, therewould be more loss of consumer surplus.


Producer surplus decreases for sure.

Some firms leave the market because the actual price is lowerthan the price they were willing to sell for.

Other firms stay in the market but receive a lower price.

Total production decreases.


If demand is very price inelastic, there will be a loss of consumersurplus due to a price ceiling.


S

D

A C

B

Q1 Q2

P0

Pmax

quantity

Price


Gasoline has a very inelastic demand in the short run.

In summer 1979, the world price of gasoline was high.

Price ceilings were imposed to keep the price low.

But consumers spent hours waiting in lines, probably made worseoff.


The efficiency of a competitive market

Situations where the competitive market does not achieveeconomic efficiency:

1. Externalities – the actions of consumers or producers lead tocosts or benefits that are not factored into the market price.

Examples: Environmental pollution, research into technology.

2. Lack of information – when consumers do not know somethingabout a product, they may not make utility-maximizing decisionsabout how much to buy. When insurance companies do not knowthe characteristics of their customers, they can’t base thepremium charged on an individual’s risk.


With no externalities and complete information, an efficientoutcome is reached by an unregulated competitive market.

Consider a price floor. The government requires buyers of a goodto pay at least a certain amount per unit.

Too much is produced (quantity supplied is greater than quantitydemanded).


AB

C

Q0 Q2Q3

P0

P2

Quantity

Price


In the above graph, producer surplus loses C but gains A.Consumer surplus loses both A and B.

Producers as a whole may be better or worse off. Consumers areworse off for sure.


As the price floor decreases to the equilibrium price, total surplusincreases.

Similarly, as a price ceiling increases to the equilibrium price,total surplus increases.

The maximum surplus possible is when there is no price floor orprice ceiling.


The Impact of a tax or subsidy

Suppose the government wants to impose a 50 cent per gallon taxon gasoline, and considers two ways of collecting it.

1. The owner of a gas station gives 50 cents to the government forevery gallon sold.

2. Anyone buying gas must send 50 cents per gallon to thegovernment.


The two methods are equivalent in the actual price consumers payand in the price sellers get.

Sellers may raise the price if they have to nominally pay the tax,so that consumers bear some of the tax burden.

The elasticities of the demand and supply curves determine howmuch of the burden is borne by buyers and sellers. The moreinelastic one side of the market is, the more of a tax burden itbears.

This formula can be used to calculate the percentage of the taxborne by buyers:

Es/(Es −Ed) =Pass-through fraction. It tells what fraction of thetax is passed on to consumers in the form of higher prices. Thefraction of the tax borne by producers is −Ed/(Es − Ed).


To find the quantity sold and prices after the tax, notice that thedifference between the price paid by buyers and the price receivedby sellers must equal the size of the tax (t).

The quantity sold and the price paid by buyers must lie on thedemand curve.

The quantity sold and the price received by sellers must lie on thesupply curve.

The quantity demanded must equal the quantity supplied.


So the effect of a tax can be represented on the graph by avertical line of length t between supply and demand curves.

A subsidy is like a negative tax. The government pays money toeither the buyer or the seller for every sale of the good.

The seller’s price exceeds the buyer’s price by the amount of thesubsidy per unit, s.


Ps

Pb

P0

Q0 Q1 Quantity

Price


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