Download Consumer`s and Producer`s Surplus

Lecture 6
Consumer’s and Producer’s Surplus
Required Text
Frank and Bernanke – Chapter 3
Market Equilibrium


Earlier, we saw that
market equilibrium occurs
when the quantity of a
good offered by sellers at
a given price equals the
quantity buyers are willing
and able to purchase at
that same price.
That is, market
equilibrium occurs at price
equals P* and quantity
equals Q*.
P
S
P*
D
Q*
Q
Measuring the Gains from Trade
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Whenever an exchange (or trade) takes place between a
consumer and a producer, both parties gain from that
exchange (or trade)
The consumer’s gain from the trade is termed as
 The consumer’s surplus
The producer’s gain from the trade is termed as
 The producer’s surplus
The sum of the consumer’s and producer’s surplus
is the total gains from a particular trade (or
exchange).
The Consumer’s Surplus
The Consumer’s Surplus is defined as the
difference between what the consumer would be
willing to pay and what the consumer actually
pays to acquire a given quantity of a good.
In other words, the consumer’s surplus is the
amount by which the value of her purchases
exceeds what she actually pays for them
A Numerical Example
Price
Quantit
y
Willing
to Pay
Actual Consum
Paymen
er
t
Surplus
15
1
15
15
0
13
2
28
26
2
10
3
38
30
8
7
4
45
28
17
5
5
50
25
25
2
6
52
12
40
1
7
53
7
46
The Consumer’s Surplus
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Note that for buying Q1 units,
consumer is willing to pay
P1/unit of product.
For buying Q2 units,
consumer is willing to pay
P2/unit of product.
But at market equilibrium,
the consumer buys Q3 units
of the product for P3/unit of
product.
Thus, at the equilibrium price
of P3/unit of product,
consumer actually ends up
paying less than what he is
willing to pay.
This difference is called the
Consumer’s Surplus.
P
S
P1
P2
P3
D
Q1
Q2
Q3
Q
The Consumer’s Surplus

In general, the
Consumer’s Surplus
can then be calculated
as the area under the
demand curve and
above the price level,
i.e., the shaded area.
P
S
P
D
Q
Q
The Producer’s Surplus
The Producer’s Surplus is defined as the dollar
amount by which a firm benefits by producing
its profit maximizing level of output.
In other words, a Producer’s Surplus is the
amount by which the producer’s revenue
exceeds her variable production costs
Producers’ Surplus





Note that for selling Q1 units,
producer is willing to accept
P1/unit of product.
For selling Q2 units, producer
is willing to accept P2/unit of
product.
But at market equilibrium, the
consumer sells Q3 units of the
product at P3/unit of product.
Thus, at the equilibrium price
of P3/unit of product, producer
actually ends up receiving
more than what he is willing
to accept.
This difference is called the
Producers’ Surplus.
P
S
P3
P2
P1
D
Q1
Q2
Q3
Q
The Producer’s Surplus

In general, Producers’
Surplus can then be
calculated as the area
above the supply
curve and below the
price level, i.e., the
shaded area.
P
S
P1
D
Q1
Q
The Consumer’s and Producer’s Surpluses
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

The Consumer’s Surplus is
given by the area under the
demand curve and above the
price level.
The Producer’s Surplus is
given by the area above the
supply curve and below the
price level.
So the Total Surplus is the
sum of the Producer’s
Surplus and the Consumer’s
Surplus
P
S
P1
D
Q1
Q
Consumer’s and Producer’s Surpluses
A Mathematical Application

Suppose that the demand and supply function are given by
 QD = 40 – 2P
 QS = 2P

Market equilibrium occurs at the intersection of the demand and
supply functions. Thus, at the market equilibrium QS = QD

Now, setting QS = QD , we have
 40 – 2P = 2P => 4P = 40 => P* = 10 (equilibrium price)
Plugging the equilibrium price to either the demand or supply
function
 QD = 40 – 2(10) => QD = 20
 QD = 20 = QS (equilibrium quantity)

Consumer’s and Producer’s Surpluses
A Mathematical Application
The consumer’s surplus is the area of the triangle between the price line
and demand curve
 For QD = 20, P = 10 (the equilibrium price and quantity exchanged)
 For QD = 0, P = 20 (this is the vertical intercept of the inverse demand
function)
 The vertical intercept above the price line is (20-10=) 10
 The area of the triangle between the price line and the demand curve, i.e.,
 CS= (1/2)*20*10 = 100
The producer’s surplus is the area of the triangle between the price line
and supply curve
 For QS = 20, P = 10 (the equilibrium price and quantity exchanged)
 The vertical intercept above the price line is 10
 The area of the triangle between the price line and the supply curve, i.e.,
 PS= (1/2)*20*10 = 100
The total surplus, TS = CS + PS = 100+100 = 200
Total Economic Surplus or
Social Surplus
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
Total Economic Surplus or Social Surplus: The sum of the
surpluses from trade of a commodity or service to all
participants (all consumers and producers)
Total economic surplus from all exchanges of a commodity
occurred at a particular point in time can be calculated in the
same way, using the aggregate (market) demand and supply
functions (curves)



Consumers’ surplus is the area of the triangle between the
equilibrium price line and the market demand curve
Producers’ surplus is the area of the triangle between the
equilibrium price line and the market supply curve
Total Economic Surplus = Consumers’ Surplus +
Producers’ Surplus
The Effect of a Sales Tax
Deadweight Loss
Excise Tax
Impacts on Consumers’ and Producers’ Surplus
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An excise tax per unit of the
commodity shifts the supply curve from
S to S1.
Resulting in a change in the equilibrium
price from P1 to P2 and equilibrium
quantity from Q1 to Q2.
Before tax CS = abP1
After tax CS = adP2
Tax decreased CS
Before tax PS = cbP1
After tax PS = edP2
Tax decreased PS
Before tax Total Surplus = abc
After tax Total Surplus = ade
Tax decreased Total Surplus
Society overall is worse off due to the
excise tax
S1
P
S
a
P2
P1
d
b
e
D
c
Q2 Q1
Q
Increase in Income
Impacts on Consumers’ and Producers’ Surplus
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Increase in income shifts the demand
curve from D to D1.
Resulting in a change in the
equilibrium price from P1 to P2 and
equilibrium quantity from Q1 to Q2.
Initial CS = abP1
Later CS = edP2
Not sure if CS increased or decreased.
Initial PS = cbP1
Later PS = cdP2
Increase in PS
Initial Total Surplus = abc
Later Total Surplus = edc
An increase in Total Surplus
Society overall is better off due to an
increase in consumer income.
P
e
S
a
P2
P1
d
b
D1
D
c
Q1
Q2
Q
Market Equilibrium: The Invisible Hand
Equilibrium Principle
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Markets communicate information effectively
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Value buyers place on the product
Opportunity cost of producing the product
When the market for a good is in equilibrium, the seller’s
cost of producing an addition unit of the good is the same
as the consumer’s benefit of having that additional unit
MC = MB
When a market is not in equilibrium, it is possible to
identify mutually beneficial exchanges.
Equilibrium Principle: A market in equilibrium leaves no
unexploited opportunities for individuals but may not
exploit all gain achievable through collective action.
Economic Efficiency
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Socially Optimal Quantity: The quantity of a good
that results in the maximum possible economic surplus
from producing and consuming the good.
Economic Efficiency: An economy is said to be
efficient when all goods and services are produced and
consumed at their respective socially optimal level
Is the market equilibrium quantity of a good efficient?

Only when the seller pays the full cost of production and the
buyer captures the full benefit of the good
 MC = MB
 the equilibrium quantity maximizes social surplus −
socially optimal
Smart for One, Dumb for All
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Producers sometimes shift costs to others
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Buyers may create benefits for others
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Pollution is like getting free waste disposal services
Total marginal cost = seller's marginal cost plus marginal
cost of pollution
When costs are shifted, supply is greater than socially
optimal
Marginal benefit is less than the full social benefit
Vaccinations, my neighbor's landscaping
The demand for these goods is less than socially optimal
Regulation, taxes and fines, or subsidies can move the
market to optimal level
Efficiency Principle
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Efficiency Principle: When the economic pie (social
surplus) grows larger through efficiency, everyone can
have a larger slice.