Maximising Consumer Surplus and Producer Surplus:

How do airlines and mobile companies do it?

This is a topic that has many powerful applications in understanding economic policy applications:

(a) the impact of many government interventions in the market and

eg tariff protection

eg import quotas

eg taxes

eg price control

(b) market imperfections such as monopolies

- price discrimination

- monopoly pricing.

Absolutely critical to understand the underlying logic.

First: Long Run Industry Supply Curves,

We have seen short run equilibrium under perfect competition

What happens in the long run?

What should the Long Run Supply curve look like?

If you could predict what the “Long Run Supply Curve” looks like for any commodity, and knowing likely demand (which is more predictable), you could make a fortune in the “Futures” market.

In reality, despite many pre-conceptions, people have not been able to predict what the long term supply curves are going to be like, even for something as critical as oil (which we looked at in our last lecture)

Suppose that demand for a product increases from D1 to D2

In the short run, price rises from Po to P1; super-profits are made, firms are

attracted into the industry and the supply curve will therefore shift out.

The question is: where will it shift to in the long run? And what will be the new

equilibrium price? Higher? Lower? or the same?

qo L

P ($)

Po

q1

A

SRS0

D2

D1

P1 B where?

Much depends on the markets for the inputs

If input markets not perfectly competitive eg limited land or limited labour

More firms buying inputs, pushes up the prices of these inputs for everyone, the ATC

curves rises for every firm; the SRS1 will not shift all that much, and the final

equilibrium price will be higher than Po.

AC then represents the Long Run Supply Curve for an “increasing cost” industry.

Eg with rising population, what will happen to the long term price of food?

qo

P ($)

Po

q1

A

SRS0

D2

D1

P1

B

SRS1

C

LRS1

ATC0

ATC1

But opposite may happen if there exist economies of scale

Where all the firms, with higher outputs, begin to produce with lower minimum ATCs

(or all on the declining part of their ATC curves)

Which implies that the SRS1 has shifted so far to the right that equilibrium price P1 is

less than Po. and the LRS1 represents a decreasing cost industry with a downward

sloping supply curve- i.e. the great boon of a “decreasing cost” industry.

qo

P ($)

Po

q1

A

SRS0

D2

D1

P1

B

SRS1

C

LRS1

ATC1

ATC0

Many examples in the electronics industry

Computers: Forty years ago, a basic computer used to cost $500,000 and

occupy a room 30 metres by 20 metres. There may have been perhaps 300,000

such computers in the world

Today, desk-tops far more powerful, far more user-friendly (look at the menu-

driven word-processing, spread-sheets, databases, modeling soft-ware). Play

CDs, DVDs, video-conferencing, electronic storage of everything,...

Also connects you to the whole world : email, Internet, persons, companies,

libraries etc etc voice, video.

Billions of computers in the world, costing less than $2000 each.

No end in sight to declining real costs and prices

Similar arguments for televisions, radios, cameras, and mobiles etc

But “in-between” “normal” case: horizontal supply curve

If the input markets are perfectly competitive, then inputs can be bought for the same

prices as originally regardless of how much of each input is purchased

Which implies that all these firms will keep producing at the bottom of the ATC curves

But there are now more firms, producing greater output

Hence the supply curve shifts to SRS1, equilibrium output is at C, and

The line AC represents the Long Run Supply Curve for a “constant cost” industry.

qo

P ($)

Po

q1

A

SRS0

D2

D1

P1

B

SRS1

C LRS1

ATC0

Hence for normal equilibrium under Perfect Competition

We have a horizontal supply curve; usual demand curve;

With equilibrium quantity Qo; and Price = MC i.e. economic efficiency

i.e. in perfect competition equilibrium

Marginal value to society = Marginal cost to society (no externalities)

But many consumers willing to pay more than Po: demand curve above Po: AB

Xo X

$

Po

O

B

S

D

A The value that society places

on each extra unit of output

The cost to society of producing

that extra unit of output

Definition of Consumer Surplus

Consumer surplus exists wherever the price paid for one unit of a product by a

consumer is less than what that consumers are willing to pay for it.

If the price is Po, then the space (green lines: gap between the price line and the

demand curve) represent the consumer surplus at each extra unit of output.

Total consumer surplus is = the area PoAB.

Xo X

$

Po

O

B

Consumer surplus at each output level

D

A

?

If price changes eg to P1 or P2 then the consumer surplus changes

If price rises to P1 then the consumer surplus declines to P1AC.

Conversely if price declines to P2, then the consumer surplus increases to P2AE

Xo X

$

Po

O

B

E

A

P1

C

P2

D

Note the importance of demand elasticities

If the demand is quite elastic (D2): ie “flatter”, then a small rise in price leads to

a large reduction in demand;

ie. if fewer consumers who are willing to pay higher prices for this commodity:

the consumer surplus is correspondingly smaller: area PoBC

What would the consumer surplus be if the demand curve was completely flat?

Xo X

$

Po

O

B

A

C

D1

D2

Interesting applications from the sellers’ point of view

If sellers can isolate all the buyers into their separate markets distinguished by

what they are willing to pay: then they could charge those with higher consumer

surplus, higher prices : And they could charge those with lower consumer

surplus, lower prices. ie practice price discrimination; but the markets must be

able to be kept separate

Three examples:

(a) Any common beverage (soft drinks or alcoholic) sold in a cafe as opposed to

an up-market resort eg Fiji stubby: $2.50 in a Chinese cafe, as opposed to $4.50

in the Holiday Inn.

(b) Airline tickets; those who plan ahead; those who have to fly urgently;

(c) mobile phone or land-line charges

Does not require monopoly for this to happen (monopoly and price

discrimination later).

How do airlines do it?

Of course, airlines could compete with other airlines simply by reducing price- all would

reduce price i.e. consumers would all be enjoying their consumer surplus. No gain to any

airline. What do airlines actually do?

Offer large discounts if you book in advance (airline gets confirmed sale, and cash in

hand - hence reduced cash-flow problem)

Closer you get to the departure date, the higher is the price for those who have to travel.

What do airlines have to do if departure date is getting closer and new bookings are not

eventuating? (especially easy given that a lot of customers are now buying online)

Sometimes just before a flight, the price drops, to fill empty seats

Is it correct that all those who book early at the lowest price available, are those whose

consumer surplus was the lowest?

Do airlines give exactly the same kinds of discounts for every destination?

How do mobile and land-line companies extract consumer surplus?

Explain why the phone companies can extract more consumer surplus by having

different basic tariff rates for:

(a) Distinguishing between pre-paid cards and post-paid cards

(b) Different rates at different times of the day

(c) Different rates for different destinations

(d) different rates for different services: what are all the different services?

(e) different groupings of customers?

(f) differentiating commercial firms from ordinary firms.

Producer surplus

Similar logic to “consumer surplus” analysis but with some subtle differences.

Simplify by passing Supply Curve through the origin

We know that at each price level the Supply curve gives the output that the firm is

willing to supply at the particular price. Anything received above that is a “gain”.

So at price Po, the area above the supply curve and below the Po line, represents the total

producer surplus enjoyed by the producer who is producing at output point Xo. (OPoB)

X

$

Po

Xo

B

O

D

C

S = sum of MC curves

Producer surplus: is not “money in the pocket” of the producers

Industry revenue = area OXoBPo.

The area under the supply curve = sum of the industry MCs = Total Variable Cost.

The industry increases output as long as MR = P > MC (which is represented by the

Supply curve: so everywhere, the “net gain” to the producer = P - MC

But of course he also has to pay his Fixed Costs

Real Net profit = OXoBPo - OBXo - Total Fixed costs

= Producer surplus OBPo - Total Fixed costs

X

$

Po

Xo

B

O

D

C

S = sum of MC curves

Producer surplus: total marginal gain of producing more

This “marginalist” reasoning about producer surplus is at the heart of marginal

analysis; once the fixed investments are made (Total Fixed Costs)

What matters for economic efficiency and the decision on the optimum amount

to produce is whether producing and selling one more unit will be such that

MR > MC and here

MR = P > MC

i.e only whether the price line is above the Supply curve.

Fascinating application to “efficiency pricing of a good produced by a state

enterprise” in a situation where “Marginal Cost is virtually 0”: the price

should be zero.

“Total Surplus”: maximum at equilibrium price

And with “Pareto Optimality” in General Equilibrium

Total Surplus = Consumer Surplus + Producer Surplus

= CPoB + OPoB.

Under perfect competition, this Total Surplus is the maximum available to the

economy.

Q

$

Po

Xo

B

O

D

C

S = sum of MC curves

Any other output level, will lead to a lower Total Surplus

Suppose the firm (for whatever reason, chooses to produce at lower output X1

New consumer surplus = CEP1

New producer surplus = OAEP1

Total Surplus has shrunk by EAB: called the “deadweight loss” to the economy.

X

$

Po

Xo

A

B

O

D

C S = sum of MC curves

P1

X1

E

F

But note by how much consumer surplus has declined by

Consumer surplus has declined by PoP1EB

But of this, one bit has been gained by the producers: PoP1EF

Where has FEB gone to?

The net change in producer surplus = - FBA + PoP1EF

Will this be positive or negative?

Where has AFB gone to? i.e. AFEB = FEB + AFB = “?????”

Q

$

Po

Xo

A

B

O

D

C S

P1

X1

E

F

Note that in neoclassical economics

The transfer of surplus from consumers to producers or from producers to consumers is

NOT seen as positive or negative, either way.

It is seen as merely a “transfer within society”.

Whether the producer is rich or poor, or the consumers are rich or poor.

For Neoclassical Economics,

there is no value judgment made about an extra dollar in the hands of a producer (even if

he is a monopolist, rich or poor) or in the hands of a consumer

What if for a PIC, the producers are companies (foreign or local) who invest overseas?

What if the consumers are foreigners? Can they be?

Suppose govt imposes price control: ie a price ceiling?

What will be new output? X1 or X2?

What will be the new consumer surplus? smaller or bigger than before?

What will be the new producer surplus? smaller or bigger than before?

What is the total surplus? bigger or smaller than before?

What is the “dead-weight loss”?

Has the economy gained or lost overall? Who gained? Who lost?

Q

$

Po

Xo

A B

O

D

C S = sum of MC curves

P1

X1

E F

X2

What if government decrees that output must increase to X2

and must be sold at price P1?

What happens to producer surplus, producing at X2?

The increase in consumer surplus = P1PoBF

Where does this increase in consumer surplus come from?

Why is output point X2 so inefficient from society’s point of view?

What is a neat geometric expression representing this “deadweight loss”?

Q

$

Xo

B

O

D

C S = sum of MC curves

X2

F

G

Po

P1