Download Chapter 4 – Consumer and Producer Surplus

Goldwasser
AP Microeconomics
Chapter 4 – Consumer and Producer Surplus
BEFORE YOU READ THE CHAPTER
Summary
This chapter develops the concepts of producer surplus, consumer surplus, and total
surplus and then illustrates the connection between these concepts and the demand and
supply model. The chapter also explains how total surplus can be used to the gains from
trade and to evaluate the efficiency of a market.
Chapter Objectives
Objective #1. The demand and supply model illustrates how much consumers and
producers gain from participating in a market. A consumer’s willingness to pay refers to
the maximum price the consumer would pay to purchase an item. The demand curve is
defined by the willingness of consumers to pay.
Objective #2. An individual’s consumer surplus is the difference between the individual’s
willingness to pay and the price he/she pays for the good: consumer surplus measures the
net gain the consumer receives when he/she purchases the good. Total consumer surplus
is the sum of the individual consumer surpluses achieved by all the buyers of the good.
Total consumer surplus is equal to the area under the demand curve but above the price.
•
The area of consumer surplus is a triangle for a smooth demand curve or a series of
rectangles for a step-shaped demand curve.
•
Holding everything else constant, a decrease in price increases consumer surplus
while an increase in price decreases consumer surplus.
Objective #3. The seller’s price is the lowest price the seller is willing to sell the good for.
Individual producer surplus is the difference between the price the good sells for and the
lowest price the seller is willing to accept for the good: individual producer surplus
measures the net gain the seller receives from selling the good. Total producer surplus is
the sum of the individual producer surplus achieved by all the sellers of the good. Total
producer surplus is equal to the area above the supply curve but beneath the price.
•
The area of producer surplus is a triangle for a smooth supply or a series of
rectangles for a step-shaped supply curve.
•
Holding everything else constant, a decrease in price decreases producer surplus
and an increase in price increases producer surplus.
Objective #4. Total surplus is the sum of consumer and producer surplus. At the market
equilibrium, total surplus is maximized: the market equilibrium allocates the consumption
of the good among potential consumers and the sales of the good among potential sellers
in order to achieve the maximum possible gains to society. In a well-functioning market,
total surplus cannot be increased by reallocating consumption among consumers,
reallocating sales among sellers, or by changing the quantity traded. In fact, each of these
actions diminishes the level of total surplus in the market.
•
Preventing a sale in a market that would have taken place in equilibrium reduces
both the consumer and producer surplus, resulting in a loss of total surplus.
Increasing sales beyond the equilibrium quantity similarly reduces consumer
surplus, producer surplus, and total surplus since such a sale would represent a
situation where the buyer’s willingness to buy must be less than the seller’s cost.
Objective #5. Total surplus is maximized at the market equilibrium: (a) the market
allocates consumption of the good to those potential consumers who place the highest
value on the good; (b) the market allocates sales of the good to the sellers who have the
lowest cost of producing the good; (c) the market ensures that any purchase represents a
situation where the buyer values the good more than the seller values the good; and (d)
the market ensures that no sales are made in which the seller values the good more than
the purchaser does. Markets are efficient when total surplus is maximized.
•
Even though the market equilibrium maximizes total surplus, this does not imply
that it maximizes the outcome for any individual buyer or seller. Subsequent
chapters consider situations of market intervention where individual buyers or
sellers are made better off than they would be at the market equilibrium.
Objective #6. Well-defined property rights are required for a market to function
effectively. Well-defined property rights identify the owner of valuable resources and
goods, and this ownership makes it possible for mutually beneficial transactions to occur.
Economic signals are also necessary for markets to function. The best economic signal is
price because price of a good conveys the consumer’s willingness to pay and the
producer’s cost.
Objective #7. Markets can fail to be efficient: this is called market failure. Markets fail
when someone prevents mutually beneficial trades from occurring, when there are side
effects that the market does not take into account, or because some goods are unsuited for
efficient management by markets. Subsequent chapters consider these situations.
Key Terms
willingness to pay the maximum price a
consumer is willing to pay for a good
individual consumer surplus the net
gain to an individual buyer for the
purchase of a good: equal to the
difference between the buyer’s
willingness to pay and the price paid
total consumer surplus the sum of the
individual consumer surpluses of all the
buyers of a good in a market
consumer surplus a term often used to
refer both to individual consumer
surplus and to total consumer surplus
cost (of seller) the lowest price at which
a seller is willing to sell a good
individual producer surplus the net gain
to an individual seller from selling a
good; equal to the difference between
the price received and the seller’s cost
producer surplus a term often used to
refer both to individual producer surplus
and to total producer surplus
total surplus the total net gain to
consumers and producers from trading
in a market; the sum of the producer
surplus and consumer surplus
property rights the rights of owners of
valuable items, whether resources or
goods to dispose of those items as they
choose
economic signal any piece of
information that helps people make
better economic decisions
inefficient describes a market of
economy in which there are missed
opportunities; some people could be
made better off without making other
people worse off
market failure occurs when a market
fails to be efficient
Notes
AFTER YOU READ THE CHAPTER
Tips
Tip #1 To master the key concept in this chapter, you must be able to locate the
areas of surplus in the graphs of the supply and demand model. You will want to
work with the concepts of consumer surplus, producer surplus, and total surplus
until you feel confident you can find these areas in your graphs.
Tip #2 Figure 4.1 illustrates the concept of consumer surplus for a step shaped
demand curve. The area of consumer surplus consists of a series of rectangles that
lie under the demand curve but above the market price. Each of these rectangles
has been shaded separately in Figure 4.1 but the area of consumer surplus is the
entire shaded area. Those consumers whose willingness to pay is equal to or
greater than the market price will purchase the good for the market price, and their
consumer surplus represents the net gain they receive from purchasing the good.
Tip #3 Figure 4.2 illustrates the concept of consumer surplus for a smooth demand
curve. The area of consumer surplus consists of the area under the demand curve
but above the market price. In figure 4.2, the area of consumer surplus is shaded.
The value of consumer surplus can be found by calculating the area of this shaded
triangle. The consumer surplus represents the net gain consumers receive from
purchasing a good.
Tip #4 Figure 4.3 illustrates the concept of producer surplus for a step-shaped
supply curve. The area of producer surplus consists of a serried of rectangles that
lie above the supply curve but below the market price. Each of these rectangles has
been shaded as separate rectangle in Figure 4.3, but the area of producer surplus is
the entire shaded area. Those producers whose willingness to sell is equal to or less
than the market price, will sell the good for the market price, and their producer
surplus represents the net gain the receive from selling the good.
Tip #5 Figure 4.4 illustrates the concept of producer surplus for a smooth supply
curve. The area of producer surplus is the shaded region above the supply curve
but beneath the market price. The value of producer surplus can be found by
calculating the area of this shaded triangle. The producer surplus represents the net
gain producers receive from selling the good.
Tip #6. Figures 4.5 and 4.6 illustrate total surplus, which the sum of consumer
surplus and producer surplus. Figure 4.5 illustrates this concept for step-shaped
demand and supply curves, and Figure 4.6 illustrates this concept for smooth
demand and curves.
Tip #7. If you are using flash cards, make sure you make up a set with this chapter’s
new vocabulary and concepts. Review all of your flash cards on a regular basis to
make sure you are not forgetting and terms or concepts.