Download Producer Surplus and the Supply Curve

Module
11
Consumer and
Producer Surplus
Module Objectives
Students will learn in this module:
• The meaning of consumer surplus and its relationship to the demand curve.
• The meaning of producer surplus and its relationship to the supply curve.
Module Outline
Opening Example: The second-hand textbook market is used to introduce the concepts of consumer and producer surplus. If students are voluntarily buying and selling
their used textbooks then both the buyers and sellers must be benefitting from these
transactions.
I.Consumer Surplus and the Demand Curve
A.Definition: A consumer’s willingness to pay for a good is the maximum price
at which he or she would buy that good.
B.Willingness to pay and consumer surplus
1. Definition: Individual consumer surplus is a net gain to an individual
buyer from the purchase of a good. It is equal to the difference between
what the buyer would have been willing to pay and what the buyer actually pays. 2. Definition: Total consumer surplus is the sum of the individual consumer surpluses of all the buyers of a good.
3. Definition: The term consumer surplus is often used to refer both to
individual and to total consumer surplus.
4. The total consumer surplus generated by purchases of a good at a given
price is equal to the area under the demand curve but above the price.
This is illustrated in text Figure 11-3, shown on the next page.
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consumer and producer surplus
Consumer Surplus
Price of
iPad
Consumer surplus
$500
Price = $500
D
0
1 million
Quantity of iPads
C. How changing prices affect consumer surplus
1. When the price of a good falls, the total consumer surplus increases
through two channels: a gain to consumers who would have bought at
the original price, and a gain to consumers who are persuaded to buy at
the lower price. When the price of a good increases, the total consumer
surplus decreases in a similar fashion.
II.Producer Surplus and the Supply Curve
A.Cost and producer surplus
1. Definition: A seller’s cost is the lowest price at which he or she is willing
to sell a good.
2. Definition: Individual producer surplus is the net gain to a seller from
selling a good. It is the difference between the market price and the seller’s cost.
3. Definition: Total producer surplus in a market is the sum of the individual producer surpluses of all the sellers of a good. Economists use the
term producer surplus to refer both to individual and to total producer
surplus.
4. The total producer surplus from sales of a good at a given price is the
area above the supply curve but below that price. This is illustrated in text
Figure 11-8, shown on the next page.
B.Changes in producer surplus
1. If the price of a good rises, producers will experience an increase in producer surplus through two channels: the gains of those who would have
supplied the good even at the original, lower price and the gains of those
who are induced to supply the good at the higher price. A fall in the price
similarly leads to a fall in the producer surplus.
module 11
consumer and producer surplus
Producer Surplus
Price of
wheat
(per bushel)
S
$5
Producer
surplus
0
1 million
Quantity of wheat (bushels)
Teaching Tips
Consumer Surplus and the Demand Curve
Creating Student Interest
Have students consider and discuss the process of buying a new car (this can also be an
opportunity to provide some instruction in real-world financial literacy). Do most people
walk into a dealership and pay the sticker price on the side of the car? Should they? Does
everyone pay the same price for the same car? Why? How has the Internet changed the
way people buy new cars? Since buyers negotiate their own deal for differentiated new cars
(including financing and trade-in) they pay different prices. What determines how much
they pay? Their willingness to pay and the amount of consumer surplus they can bargain for.
Ask students if they have ever entered a store expecting to pay a certain price for a good (for
example, $10 for a book) and found that the book was on sale for $8. Have them imagine
that it happens. Would they pay the $10, or only $8? How would they feel about paying
less?
Another example is going to buy a good (for example, toothpaste) and finding a valid
coupon for the toothpaste you want sitting on the shelf next to it. Would they use the
coupon, and how would they feel about it? Coupons are often left around stores (or
dispensed from a machine provided by the store). Perhaps they are left by the consumer
surplus fairy!
Presenting the Material
Students rarely have difficulty understanding the basic concept of consumer surplus. They
understand there is a difference between the amount they are willing to pay for a good and
the price the store is charging. They know that when a good goes on sale they are getting
a better deal, and at this point you can tell them that this savings represents consumer
surplus. Move from the basic concept and definition of consumer surplus to a table like the
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one below. Students will generally be able to calculate individual and total surplus from the
table. Point out that when the willingness to pay is less than the actual price, the person
will choose not to buy the good. Before moving on to the graph, ask them what they think
happens to consumer surplus when price changes.
Willingness to pay
for 1 hour of math tutoring
Actual market price for one hour of
math tutoring
Consumer surplus
Jack’s willingness to pay = $24
$10
$14
Karla’s willingness to pay = $21
10
11
Harold’s willingness to pay = $18
10
8
Kathy’s willingness to pay = $10
10
0
Chester’s willingness to pay = $5
10
n/a
Moving from the table to the graph can be challenging for some students. Start by plotting the price quantity points for the five people in the table on the graph. Next, draw the
demand curve as a step graph. Tell them the steps exist because you are only sellling five
whole units to five individuals, which means you must lower the price by a significant
amount each time before another buyer jumps into the market. The step graph will make
the geometry of consumer surplus easier to understand. Once they have grasped the idea
that consumer surplus is the area under the demand curve and above the price line,
transition back to the normal demand curve. Explain that each point on the demand
curve represents an amount that someone is willing to pay. Draw vertical lines from the
demand curve to the price line to represent the individual consumer surplus.
Price
$25
20
15
10
5
0
1
2
3
4
5
Quantity
module 11
consumer and producer surplus
Producer Surplus and the Supply Curve
Creating Student Interest
Ask students what determines the lowest price a seller is willing to sell a good for. Help
students see that this price will be equivalent to the seller’s cost. The cost in this case
represents all the opportunity costs of the seller.
Return to the new car example. Ask about the motivations of the seller—what is the seller
trying to do? (maximize their producer surplus) What determines the lowest price the
seller will take? (their costs, including opportunity costs, and their minimum acceptable
profit) What information do they use to determine how high they can set the price of
the new car? (information about demand and the consumer’s willingness to pay) The car
dealer is trying to maximize producer surplus (and minimize consumer surplus) while
the buyer is trying to do the opposite.
Presenting the Material
Students often have more trouble understanding producer surplus, perhaps because they
are not used to thinking of themselves as sellers of a good. Emphasize that the seller is
willing to sell a good for any price that at least covers his cost of production. The greater
the price compared with the cost of production, the higher the producer surplus. To
present the concept of producer surplus, take the same approach used earlier to present
consumer surplus. Start with the data in the table below, then progress to the step graph,
and finally the regular supply curve. Make clear that we are now looking at tutors and
their willingness to sell their services. The opportunity cost of using their time in tutoring
is equal to the forgone value of that time in other activities.
Seller’s minimum price to sell (= the seller’s Actual market price
opportunity cost)
for tutoring
Producer surplus
Jane’s price = $12
$10
n/a
Dora’s price = $10
10
$0
Lee’s price = $8
10
2
Sam’s price = $6
10
4
Kathy’s price = $4
10
6
The total surplus is the sum of the individual seller’s producer surplus. Here it is equal
to $12. Again, you can change the price to chow the effect on the total producer surplus.
Common Student Pitfalls
• The area of a triangle. Students may have forgotten how to calculate the area of
a triangle. Review the formula ½ (base)(height) or (bh/2).
• Calculating consumer surplus. Students can usually understand consumer surplus
for an individual unit or person, but have difficulty moving to the total consumer
surplus. Be sure to show how adding up all the discrete units and moving to continuous units give us the consumer surplus triangle. Make sure students understand that
consumer surplus is measured in dollars and show how much consumers were willing to pay for the equilibrium quantity, but didn’t have to. Gaining consumer surplus
adds to consumer welfare—it gives consumers a warm fuzzy feeling to get a good for
less than they would have paid for it!
• Calculating producer surplus. Students can have the same problems understanding producer surplus as they had with consumer surplus. However, the process of
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learning consumer surplus can make understanding producer surplus easier (or
serve to point up the fact that they didn’t understand consumer surplus in the first
place). Emphasize that these are parallel ideas. In addition, students may be unclear
about the “cost”of a used textbook they plan to sell. Explain that the true cost is
their opportunity cost: They are giving up the ability to use the textbook for other
purposes, such as a reference for upper division microeconomics. Case Studies in the Text
Economics in Action
A Matter of Life and Death—This EIA presents the allocation of transplant kidneys based
on “net benefit” and explains how the approach is similar to a competitive market allocation based on consumer surplus.
Activities
What’s Your Bid? (3–5 minutes)
Ask for five volunteers and have them write down on a piece of paper the maximum price
they would be willing to pay for a textbook. Then have the students share this with the
whole class. Tell them that the used price for their text is $35 (or a representative price).
Compute each individual’s consumer surplus.
What’s a New Drug Worth? (3–5 minutes)
Pair students and ask them how they would go about assigning a monetary value to the
benefit of a new drug on the market which cures autoimmune diseases. Ask a few pairs
to report their calculations. (The benefits of the drug may be much larger than what is
actually spent on it, because people may be willing to pay more than the actual price of
the good. To measure the gains of the drug, we have to figure out what people would be
willing to pay for the drug and subtract what they actually pay.)
What’s Your Minimum Offer Price? (2–3 minutes)
Ask students to write down a minimum price they would accept to sell their textbook at
the end of the semester. Ask them to share how they estimated its dollar value to them. Put four or five responses on the board and given the bookstore’s repurchase price, form
students into pairs, then have each pair calculate the producer surplus.
What’s an Internship Worth? (2–3 minutes)
Give the class the following scenario: You have the opportunity of doing a summer
internship abroad for 3 months for a fixed salary of $800 per month, but the costs
of rent, food, and travel expenses are not included. What is your producer surplus?
(Students will have to subtract their estimated rent, food, and travel expenses from their
salary.)
Web Resources
The following website presents 10 steps to buying a new car. You can use this website to
discuss the new-car buying process and ways to increase consumer surplus when buying
a new car. http://www.edmunds.com/advice/buying/articles/78386/article.html.
The web address for eBay is http://www.ebay.com/. Look around this auction website if
you have not ever been there (many of your students will have been).