Welfare Economics Consumer Surplus and Producer Surplus.

Welfare Economics

Consumer Surplus and Producer Surplus

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Revisiting The Market Equilibrium

• The theory of supply and demand shows how markets allocate scarce resources among competing needs.

• But are the equilibrium price and the equilibrium quantity the right price and the right quantity from society’s point of view?

• This question takes us into welfare economics.

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Welfare Economics• Welfare economics is the study of how the

allocation of resources affects economic well-being

• It shows that:– Both buyers and sellers receive benefits from taking

part in the market– The equilibrium outcome in the theory of supply

and demand maximizes the total welfare of buyers and sellers

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Two main concepts

• When buyers and sellers trade willingly, it must be because they expect to benefit

• Consumer surplus measures economic welfare of the buyers.

• Producer surplus measures economic welfare of the sellers.

CONSUMER SURPLUS

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Willingness to pay• To define consumer surplus we first need to

define “willingness to pay.” • Willingness to pay is the maximum amount

that a buyer will pay for a good.• It measures how much the buyer values the

good.

Willingness to pay: background

• Assume there is a commodity such that every additional unit of it increases a consumer’s happiness by the same amount– In other words, the consumption of additional units of

this commodity induces neither boredom nor addiction

– Possible examples: potato chips? candy?• Then the consumer’s willingness to pay for a

product is a good measure of the happiness that he or she gets from it

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• Suppose a bag of potato chips provides a fixed amount of happiness

• If your willingness to pay is – 4 bags of potato chips for a shirt, and – 2 bags of potato chips for a cup of coffee, then – one can safely say that the shirt makes you twice

as happy as the cup of coffee• So, your willingness to pay for a commodity is

a good measure of how much you like it8


• If the dollar price of a bag of potato chips is known, willingness to pay in the example above can also be expressed in dollars

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• Another example: – if you are willing to pay $15 for a shirt, and– if a bag of potato chips

• always gives you 3 “haps” of happiness, and • sells at the price of $0.50 each, then

– the shirt gives you 90 “haps” of happiness.

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• In other words, your willingness to pay for the shirt is – a monetary measure of the happiness you get

from the shirt, and– it is proportional to the happiness you get from

the shirt, as measured in “haps”

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Table 1 Four Possible Buyers’ Willingness to Pay

For a mint-condition recording of Elvis Presley’s first album

12I will illustrate consumer surplus through this extended example.

Consumer Surplus

Buyer Willingness to Pay Consumer Surplus

Buy?

John 100 25 YesPaul 80 5 YesGeorge 70 -5 NoRingo 50 -25 No

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• Consumer surplus is the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it.– Example: If the Elvis album’s price is $75…

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Market Demand• The market demand shows the quantities

demanded by buyers at different prices. • We can use the willingness-to-pay numbers to

calculate the market demand– See the next slide

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The Demand ScheduleBuyer Willingness

to Pay

John 100

Paul 80

George 70

Ringo 50

Figure 1 The Demand Curve

Copyright©2003 Southwestern/Thomson Learning

Price ofAlbum

0 Quantity ofAlbums

Demand

1 2 3 4

$100 John’s willingness to pay

80 Paul’s willingness to pay

70 George’s willingness to pay

50 Ringo’s willingness to pay

Buyer Willingness to Pay

John 100

Paul 80

George 70

Ringo 50

The height of the demand curve at any quantity shows the willingness to pay of whoever bought the last unit.

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Area of a Rectangle

Height

Width

Area = Width × Height

Figure 2 Measuring Consumer Surplus with the Demand Curve

(b) Price = $70.01Price of

Album

50

70

80

0

$100

Demand

1 2 3 4 Quantity ofAlbums


Consumer Surplus

Buy?

John 100 30 Yes

Paul 80 10 Yes

George 70 0 No

Ringo 50 -20 No

John’s willingness to pay Paul’s willingness to pay

1. The area under the demand curve measures the total willingness to pay for the quantity demanded.

2. It is also the maximum willingness to pay that could be generated from that quantity.

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Interpersonal comparability

• We just saw – that the total area under the demand curve is

$180, and – that is also the total willingness to pay of John and

Paul• But can we say it is the total happiness of John

and Paul?

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Interpersonal comparability• Yes,

– if there is a commodity—say, a bag of potato chips—that provides an unchanging amount of happiness to the consumer, and

– if John’s happiness and Paul’s happiness are comparable, and

– if both John and Paul get the same happiness from a bag of potato chips

• That’s a lot of if’s! • But we will make these simplifying assumption anyway

– Not just for John and Paul, but for everybody

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Utilitarianism• The idea that

– the happiness of an individual can be measured numerically,

– the happiness of a group of people can be measured numerically,

– the happiness of a group of people is simply the sum of the numbers representing the happiness of the individual members of the group, and that

– social policy should seek to maximize the total happiness of society,

– is called utilitarianism• Welfare analysis in this course takes utilitarianism as its

guiding philosophy23

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The market and the planner• Suppose the government has two

copies of the Elvis album. The government’s goal is to give them to two of the four guys so as to generate the maximum happiness.

• Who will get the government’s copies?• Obviously, John and Paul, same as in

the market outcome we saw before.• So, the market does the best that the

government could have done

Price = $70


John 100

Paul 80

George 70

Ringo 50

Willingness to Pay from the Demand Curve

Quantity

Price

0

Demand

P1

Q1

B

A

C

The area under the demand curve measures the total willingness to pay of the consumers who bought Q1 units. It also measures the maximum willingness to pay that could be obtained from Q1 units

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Using the demand curve to measure willingness to pay

• In general, the area under the demand curve up to the quantity demanded is a graphical measure of the total willingness to pay of the buyers.

• It is also the maximum willingness to pay that can be obtained from that quantity– That is, the government could not give away that

quantity in a way that generates higher willingness to pay.

Figure 3 How the Price Affects Consumer Surplus

Consumersurplus

Quantity

(a) Consumer Surplus at Price P

Price

0

Demand

P1

Q1

B

A

C

Total Payment

Consumer Surplus (ABC) + Total Payment (OBCQ1) = Willingness to Pay (OACQ1)

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Using the Demand Curve to Measure Consumer Surplus

• In general, the area below the demand curve and above the price measures the consumer surplus.

Figure 3 How the Price Affects Consumer Surplus

Initialconsumer

surplus

Quantity

(b) Consumer Surplus at Price P

Price

0

Demand

A

BC

D EF

P1

Q1

P2

Q2

Consumer surplusto new consumers

Additional consumersurplus to initial consumers

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Shifts in Demand

• We know that the demand curve can shift, for reasons such as– a change in tastes, and– a change in the prices of related goods

• Given that the demand for a product can shift as a result of a change in the price of a related good, does it make sense to say that the area under the demand curve measures the happiness consumers get from the product?

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Shifts in Demand• Continued from the previous slide• Yes!

– Keep in mind that the area under the demand curve is a monetary measure of the happiness obtained by buyers

– The objective or psychological happiness obtained from a shirt may be unchanged even if the monetary willingness to pay for the shirt changes, perhaps because of a change in the price of a related good

• In an earlier slide, a bag of potato chips was assumed to always provide 3 “haps” of happiness, and sold at a price of $0.50. Consequently, consumers were wiling to pay $15 for a shirt that provided 90 “haps” of happiness.

• It follows that if the price of a bag of potato chips rises to $1, consumers would then be willing to pay $30 for the same shirt, leading to an upward shift in the demand curve for shirts.

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PRODUCER SURPLUS

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Producer Surplus• Producer surplus is the amount a seller is paid

for a good minus the seller’s cost. • It measures the net benefit to sellers• It is almost but not quite the same as profit.

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Cost of production

• The cost of production is the market value of all resources used in production– By all, I do mean all. – Even if some resources used in production were

obtained for free, their market value must be included in cost.

Table 2 The Cost of Painting a House for Four Possible Sellers

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Costs → Supply

• The supply of house painting services shows the quantity of house painting services supplied at all possible prices

• The cost numbers in the previous slide can be used to calculate supply of house painting services

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Costs → Supply

Seller Cost ($)

Mary 900

Frida 800

Georgia 600

Grandma 500

Figure 4 The Supply Schedule and the Supply Curve

Seller Cost ($)

Mary 900

Frida 800

Georgia 600

Grandma 500

The height of the supply curve at any quantity shows the production cost to whoever produces the last unit.

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Producer Surplus• Producer surplus is the amount a seller is paid minus

the seller’s cost– Example: If the going price for getting a house painted is

$700 we get the following table.

Seller Cost ($) Producer Surplus

Sell?

Mary 900 -200 No

Frida 800 -100 No

Georgia 600 100 Yes

Grandma 500 200 Yes

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Using the Supply Curve to Measure Producer Surplus• The area below the price and above the supply

curve measures the producer surplus.

Figure 5 Measuring Producer Surplus with the Supply Curve

Quantity ofHouses Painted

Price ofHouse

Painting

500

800

$900

0

600

1 2 3 4

(b) Price = $799.99

Supply


Sell?

Mary 900 -100 No

Frida 800 0 No

Georgia 600 200 Yes

Grandma 500 300 Yes

Grandma’s costGeorgia’s cost

1. The area under the supply curve is the cost of the quantity supplied

2. It is also the lowest cost for that quantity

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Is there a better alternative to the market system?

• If the government had to get two houses painted, who would get the job?

• Grandma and Georgia, of course.• And, as we just saw, that’s exactly

what happens in the market outcome.

• So, the market achieves the best that the government could have achieved

Seller Cost ($)

Mary 900

Frida 800

Georgia 600

Grandma 500


Sell?

Mary 900 -100 No

Frida 800 0 No

Georgia 600 200 Yes

Grandma 500 300 Yes

Figure 5 Measuring Producer Surplus with the Supply Curve

Quantity ofHouses Painted

Price ofHouse

Painting

500

800

$900

0

600

1 2 3 4

(b) Price = $800

Georgia’s producersurplus ($200)

Totalproducersurplus ($500)

Grandma’s producersurplus ($300)

Supply

1. The rectangular area under the price and up to the quantity supplied is the Total Revenue.

2. The area under the price and above the supply is the Producer Surplus.

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Figure 6 How the Price Affects Producer Surplus

Producersurplus

Quantity

(a) Producer Surplus at Price P

Price

0

Supply

B

A

C

Q1

P1

Production Cost

Total Revenue (OBCQ1) =Production Cost (OACQ1) + Producer Surplus (ABC)

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Figure 6 How the Price Affects Producer Surplus

Quantity

(b) Producer Surplus at Price P

Price

0

P1B

C

Supply

A

Initialproducersurplus

Q1

P2

Q2

Producer surplusto new producers

Additional producersurplus to initialproducers

D EF

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Figure 7 Consumer and Producer Surplus in the Market Equilibrium

Producersurplus

Consumersurplus

Price

0 Quantity

Equilibriumprice

Equilibriumquantity

Supply

Demand

A

C

B

D

E

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Welfare Economics Consumer Surplus and Producer Surplus.

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