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Econ 101: Principles of Microeconomics
Chapter 4: Consumer and Producer Surplus
Fall 2010
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Ch. 4: Consumer and Producer Surplus
Fall 2010
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Outline
1
Consumer Surplus and the Demand Curve
2
Producer Surplus and the Supply Curve
3
Total Surplus and the Gains from Trade
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Ch. 4: Consumer and Producer Surplus
Consumer and Producer Surplus
We’ve already talked about the notion of efficiency, noting that the
market usually lead to efficient outcomes (Principle #8).
We’ve also noted that that there are gains from trade through
specialization (Principle #5).
Some natural questions we might ask are:
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Is there a way to measure (i.e., quantify) the gains from trade?
Similarly, when there are inefficiencies in the market (either intentional,
as a means of achieving equity, or unintentional, due to market failure
or intervention in the market), can we measure the corresponding loss?
In this chapter, we introduce the notions of consumer surplus and
producer surplus to answer these questions.
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Consumer Surplus and the Demand Curve
Marginal Willingness-to-Pay
The demand curve provides a graphical depiction of the quantity
demanded of a good at various price levels.
Another useful way of looking at the demand curve is as measuring
the consumer’s marginal willingness-to-pay (or MWTP) for a good.
The MWTP is the maximum price the individual would be willing to
pay for the next unit of the good or service.
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Consumer Surplus and the Demand Curve
An Example: Joseph’s MWTP for Shoes
Suppose we know that Joseph has the following MWTP for shoes
Quantity Joseph’s MWTP
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$120
2
$100
3
$80
4
$60
Notice that the MWTP declines as the quantity goes up.
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Consumer Surplus and the Demand Curve
Joseph’s MWTP Graphically
The MWTP generates Joseph’s demand curve.
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Ch. 4: Consumer and Producer Surplus
Consumer Surplus and the Demand Curve
Consumer Surplus for the Individual
So, what is the net gain to Joseph if he buys 2 pairs of shoes at $90
per pair?
Well, he would have been willing to pay $120 for the first pair, but
only paid $90, for a net gain (or surplus) of $120 - $90 = $30.
For the second pair, his surplus is smaller, since he is only WTP $100
for the second pair of shoes.
In this case, the surplus is $100 - $90 = $10.
Joseph’s total consumer surplus is $30 + $10 = $40
Graphically, this total surplus is the area above the market price and
below the individual’s demand curve.
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Consumer Surplus and the Demand Curve
Joseph’s Consumer Surplus Graphically
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Ch. 4: Consumer and Producer Surplus
Consumer Surplus and the Demand Curve
More than One Consumer
Suppose we now have several consumers in the market for shoes, with
MWTP’s
Price
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2
3
4
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Joseph
120
100
80
60
Michael
110
70
30
0
John
90
65
40
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Ch. 4: Consumer and Producer Surplus
Mary
85
75
65
25
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Consumer Surplus and the Demand Curve
Individual MWTP Graphs
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Consumer Surplus and the Demand Curve
The Market Demand for Shoes
The market will naturally organize itself from highest to lowest MWTP
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Consumer Surplus and the Demand Curve
What would be the Consumer Surplus with P=70?
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Consumer Surplus and the Demand Curve
Consumer Surplus
In a large market, or in a market where quantities need not be
integers, the demand curve is typically drawn as smooth
Consumer surplus is still the area above the price and below the
demand curve
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Consumer Surplus and the Demand Curve
What Happens to CS if Price Falls?
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Ch. 4: Consumer and Producer Surplus
Producer Surplus and the Supply Curve
The Producer Side
Now let’s look at that producer’s side of the problem.
The supply curve tells us the quantity supplied at each price
level,. . . but it also can be interpreted as indicating the marginal cost
of producing one more unit.
The marginal cost will be the lowest price at which the producer
would be willing to sell the next unit of the good or service.
Don’t forget that when we talk about costs, we are referring to the
opportunity cost.
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Producer Surplus and the Supply Curve
Consider a Single Producer of Shoes - Sam
Quantity
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2
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4
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Sam’s MC
$20
$40
$80
$100
Ch. 4: Consumer and Producer Surplus
Producer Surplus and the Supply Curve
Sam’s Marginal Cost Curve
The MC generates Sam’s supply curve.
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Producer Surplus and the Supply Curve
Producer Surplus for the Individual
So, what is the net gain to Sam if he sells 2 pairs of shoes at $70 per
pair?
Well, the first pair of shoes cost him $20 to produce, but he sold
them for $70, for a net gain (or surplus) of $70 - $20 = $50.
For the second pair, his surplus is smaller, since they cost him $40 to
produce.
In this case, the surplus is $70 - $40 = $30.
Sam’s total producer surplus is $40 + $30 = $70
Graphically, this total surplus is the area above the producer’s supply
curve and below the price.
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Producer Surplus and the Supply Curve
Sam’s Producer Surplus Graphically
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Producer Surplus and the Supply Curve
More than One Producer
Suppose we now have several producers in our shoe market, with MC’s
Price
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2
3
4
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Sam
20
40
80
100
Annie
40
80
120
160
Mark
25
50
75
100
Ch. 4: Consumer and Producer Surplus
Cathy
50
60
70
80
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Producer Surplus and the Supply Curve
Individual MC Graphs
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Producer Surplus and the Supply Curve
The Market Supply for Shoes
The market will naturally organize itself from lowest to highest MC
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Producer Surplus and the Supply Curve
What would be the Producer Surplus with P=70?
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Producer Surplus and the Supply Curve
Producer Surplus
In a large market, or in a market where quantities need not be
integers, the supply curve is typically drawn as smooth
Producer surplus is still the area above the supply curve and below
the price
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Producer Surplus and the Supply Curve
What Happens to PS if Price Rises?
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Total Surplus and the Gains from Trade
Total Surplus and the Gains from Trade
If we put both of these pieces together (i.e., supply and demand), we
can see (and measure) the gains from trade.
We saw in the last chapter that market forces will cause price to
change until the quantity supplied just equals the quantity demanded.
This equilibrium results in gains for both sides of the market
- Consumers gain in the form of consumer surplus, with those buying
paying less (or at least no more) than their MWTP for the goods they
buy.
- Producers gain in the form of producer surplus, with those selling
receiving more (or at least no less) than their MC of production.
More impressive is the fact that this allocation is efficient. . . ; i.e.,
there is no way to move from this equilibrium that will make some
people better off, without making other people worse off.
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Total Surplus and the Gains from Trade
Graphically
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Total Surplus and the Gains from Trade
What Happens if...
...we artificially hold back production
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Ch. 4: Consumer and Producer Surplus
Total Surplus and the Gains from Trade
Efficiency and the Market
Any reallocation of buyers or sellers will reduce the overall surplus.
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Total Surplus and the Gains from Trade
The Efficient Market
The Efficient Market Performs Four Key Functions
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It allocates consumption of the good to the potential buyers who value
it the most,
It allocates sales to the potential sellers who most value the right to
sell the good (i.e., those who have the lowest cost)
It insures that every buyer values the good more than every seller who
sells the good (i.e., there is a surplus from the trade)
It insures that every consumer who doesn’t buy the good values it less
than every seller who does not sell the good (i.e., there are no
additional gains from trade).
There are several important caveats
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Efficient markets are not necessarily equitable;
Markets can fail
While markets maximize total surplus, they do not maximize the
surplus of individuals in the market;
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Total Surplus and the Gains from Trade
Keys to the Market Functioning Well
There are two keys to the market functioning well
1 Property Rights; i.e., the rights of owners of valuable item to dispose
of them as they choose.
An example system would include
Universality requires that all resources are privately owned and all
entitlements completely specified,
Exclusivity requires that all benefits and costs accrued as the result of
owning and using the resources should accrue to the owner, and only
the owner, either directly or indirectly by sale to others.
Transferability requires that all property rights should be transferable
from one owner to another in a voluntary exchange.
Enforceability requires that property rights should be secure from
seizure or encroachment by others
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An Economic Signal; i.e., any piece of information that helps people
make better economic decisions.
Prices are the key signal in a market economy, but not always perfect.
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Total Surplus and the Gains from Trade
Government Intervention
As Krugman and Wells note in their Principle #9: “When markets
don’t achieve efficiency, government intervention can improve
society’s welfare” resulting from
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poorly defined property rights;
inaccuracies of price as economic signals.
The authors note three key problem areas:
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Market power
Externalities
Goods (e.g., public goods, common property resources, etc.) that by
their nature are unsuited to traditional markets or property right
assignments.
While it is true that government intervention can improve welfare, it
is not necessarily the case that they will improve welfare.
Understanding the unintended consequences of market interventions
is key to setting public policy.
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