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Principles of Microeconomics Consumer Surplus and Producer Surplus 1 Welfare Economics • How the allocation of resources and market outcomes affect economic well-being • Reaching equilibrium: maximizes welfare (in most cases) • Welfare Economics: Consumer Surplus, Producer Surplus and Total Surplus 2 Consumer Surplus Willingness to pay – price actually paid • Every buyer has a maximum price they are willing to pay for every good • At lower prices, his consumer surplus is larger – he is “better off” because not paying his full maximum price 3 Consumer Surplus Willingness to pay – price actually paid • Every buyer has a maximum price they are willing to pay for every good • At lower prices, his consumer surplus is larger – he is “better off” because not paying his full maximum price 4 Consumer Surplus Consider what you would pay for a bottle of water at a summer concert • If the price of water is actually $2.50 per bottle, would you buy the water? P $2.50 – If your max price is $5 then yes! Your consumer surplus is $2.50 – If your max price is $2 then no CS • What happens if the price falls to $70 per day? Q – If your max price is $100: Your consumer surplus rises to $30 – If yous max price is $85 – now you buy the tickets and have positive consumer surplus of $15 5 Consumer Surplus Consider what you would pay for a bottle of water at a summer concert • If the price of water is actually $2.50 per bottle, would you buy the water? P $2.50 – If your max price is $5 then yes! Your consumer surplus is $2.50 – If your max price is $2 then no CS NEW CS $1.50 • What happens if the price falls to $1.50 per day? Q – If your max price is $5: Your consumer surplus rises to $3.50 – If your max price is $2 – now you buy the water and have positive consumer surplus of $1 6 Producer Surplus Price actually received – willingness to sell • Every seller faces a minimum value they are willing to accept to sell their goods • This reflects the cost of production • At higher prices, his producer surplus is larger – he is “better off” from selling his goods above cost 7 Producer Surplus Price actually received – willingness to sell • Every seller faces a minimum value they are willing to accept to sell their goods • This reflects the cost of production • At higher prices, his producer surplus is larger – he is “better off” from selling his goods above cost 8 Producer Surplus Consider independent food and beverage vendors at the summer music festival, each with the following willingness to sell a bottle of water: Willingness to sell Vendor A $3.00 Vendor B $2.75 Vendor C $2.00 9 Producer Surplus • If the price of a bottle of water is $2.25, how many vendors will sell water? P – Only vendor C – P.S. will be $0.25 $2.25 • What happens if the price rises to $3.50 per bottle? PS Q – – – – All vendors will sell water PS Vendor A: $0.50 PS Vendor B: $0.75 PS Vendor C: $1.50 10 Producer Surplus • If the price of a bottle of water is $2.25, how many vendors will sell water? P – Only vendor C – P.S. will be $0.25 $3.50 New PS $2.25 • What happens if the price rises to $3.50 per bottle? PS Q – – – – All vendors will sell water PS Vendor A: $0.50 PS Vendor B: $0.75 PS Vendor C: $1.50 11 Total Economic Surplus Combines consumer surplus and producer surplus Total Surplus = (Willingness to pay – price actually paid) + (Price actually received – willingness to sell) Total Surplus = Willingness to pay - Willingness to sell or Total Surplus = Value to Buyers – Cost to Sellers Total Surplus and Free Market Outcomes Free market allocation of resources produces most efficient outcomes: • Buyers who value them most highly, as measured by their willingness to pay. P CS $2.75 • Sellers who can produce them at the lowest cost. PS Q The free market yields an equilibrium quantity and price that maximizes both consumer and producer surplus 13 Total Surplus and Free Market Outcomes P • GOODS WILL BE ALLOCATED TO: • Buyers who value them most highly, as measured by their willingness to pay. CS $2.75 PS • Sellers who can produce them at the lowest cost. Q The free market yields an equilibrium quantity and price that maximizes both consumer and producer surplus 14 Application Consider the following demand and supply equations: Demand: Q = 3600 – 100P Supply: Q = 300P • Solve for the market equilibrium quantity and price • What is the consumer surplus? • What is the producer surplus? Application • Solving for market equilibrium: Demand = Supply 3600 – 100 P = 300P 3600 = 400 P P = 9; Q = 2700 • Solving for consumer surplus: When Q = 0 3600 = 100 P; P = 36 CS = ½ (36 – 9) * 2700 = 36,450 • Solving for producer surplus: When Q = 0 P = 0 PS = ½ (9-0)* 2700 = 12,150 Application Reflection Why does this matter? • • • We can derive the equilibrium point mathematically and determine the size of consumer surplus and size of producer surplus based on the area of the triangles CS = AREA ABOVE PRICE & BELOW DEMAND PS = AREA BELOW PRICE & ABOVE SUPPLY What’s the most important takeaway? • • • Quantifying the size of consumer surplus and producer surplus Next: we will see how it changes when there are changes in the market We will be able to quantify the size of those changes and determine who is more affected by the change MUDDIEST POINT? Key Takeaways • Welfare Economics is the analysis of the economic well-being of producers and consumers • Assume that market outcomes lead to maximized total surplus 18