Download Lesson I-5: Surplus and Efficiency, Chapter 4

Lesson Overview
Chapter 4 Surplus and Efficiency
Consumer Surplus
How Price affects Consumer Surplus
Producer Surplus
How Price affects Producer Surplus
Who Cares about Total Surplus?
Optimality of Competitive Markets
Efficiency of Competitive Markets
Inefficiency from Market Failure
Controversy: Affirmative Action
Summary
Review Questions
BA 210 Lesson I.5 Surplus and Efficiency
1
Consumer Surplus
• Consumer surplus measures the gains to consumers from
trade.
• Producer surplus measures the gains to producers from trade.
• Consumer surplus plus producer surplus can measure a
nation’s prosperity more accurately than GDP (gross domestic
product).
• The concepts of consumer surplus and producer surplus can
help us understand why markets are an efficient way to
organize trade.
• Consumer surplus is also a potential source of extra profits to
monopolist firms charging fees to customers (like Disneyland
charging an admission fee, or Costco a membership fee).
BA 210 Lesson I.5 Surplus and Efficiency
2
Consumer Surplus




A consumer’s willingness to pay for a good is the maximum
price at which he or she would buy that good.
Individual consumer surplus is the net gain to an individual
buyer from the purchase of a good. It is equal to the difference
between the buyer’s willingness to pay and the price paid.
Total consumer surplus is the sum of the individual consumer
surpluses of all the buyers of a good.
Consumer surplus can be computed if consumption quantities
are discrete (integers 0, 1, 2, … like pairs of shoes) or
continuous (real numbers including factions like pounds of
meat).
BA 210 Lesson I.5 Surplus and Efficiency
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Consumer Surplus
First, consider discrete units of books …
Potential
buyers
Price of
books
$59
Aleisha
Brad
45
Claudia
35
Darren
25
Edwina
10
D
0
1
2
3
4
5
Quantity of books
Willingness
to pay
Aleisha
Brad
$59
Claudia
35
Darren
Edwina
25
45
10
A consumer’s
willingness to pay for a
good is the maximum
price at which he or she
would buy that good.
Willingness to pay
defines a demand curve.
BA 210 Lesson I.5 Surplus and Efficiency
4
Consumer Surplus
Price of book
Aleisha’s consumer surplus:
$59-$39=$29
$59
Aleisha
Brad’s consumer surplus:
$45-$30=$15
45
Brad
35
Claudia’s consumer
surplus: $35-$30=$5
Claudia
30
Price = $30
25
The total consumer
surplus is given by the
entire shaded area - the
sum of the individual
consumer surpluses of
Aleisha, Brad, and
Claudia - equal to
$29 + $15 + $5 = $49.
Darren
10
Edwina
D
0
1
2
3
4
5
Quantity of books
BA 210 Lesson I.5 Surplus and Efficiency
5
Consumer Surplus
Next, consider continuous units, or discrete units when there are
large numbers of units …
Price of
computers
The total consumer surplus
generated by purchases of a
good at a given price is equal
to the area below the demand
curve but above that price.
Consumer
surplus
$1,500
Price = $1,500
D
0
1 million
Quantity of computers
BA 210 Lesson I.5 Surplus and Efficiency
6
How Price affects Consumer Surplus

A fall in the price of a good increases consumer surplus in two
ways:
• A gain to consumers who would have bought at the
original price and
• A gain to consumers who are persuaded to buy by the
lower price.
BA 210 Lesson I.5 Surplus and Efficiency
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How Price affects Consumer Surplus
First, see the change in discrete units of books …
Price of
book
$59
Aleisha
Increase in Aleisha’s
consumer surplus
Increase in Brad’s
consumer surplus
45
Brad
Claudia
35
Increase in Claude’s
consumer surplus
30
Original price = $30
Darren
25
20
New price = $20
Darren’s
Edwina consumer surplus
10
D
0
1
2
3
4
5
Quantity of books
BA 210 Lesson I.5 Surplus and Efficiency
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How Price affects Consumer Surplus
Next, see the change in continuous units, or large numbers …
Price of
computers
Increase in consumer
surplus to original
buyers
$5,000
Consumer surplus
gained by new
buyers
1,500
D
0
200,000
1 million
BA 210 Lesson I.5 Surplus and Efficiency
Quantity of computers
9
Producer Surplus

A potential seller’s cost is the lowest price at which he or she
is willing to sell a good.

Individual producer surplus is the net gain to a seller from
selling a good. It is equal to the difference between the price
received and the seller’s cost.

Total producer surplus in a market is the sum of the individual
producer surpluses of all the sellers of a good.
BA 210 Lesson I.5 Surplus and Efficiency
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Producer Surplus
The Supply Curve for Used Textbooks
Price of
book
Potential
sellers
S
$45
Engelbert
Engelbert
Donna
25
Carlos
15
Betty
Andrew
$5
Betty
Andrew
5
0
$45
$35
$25
$15
Carlos
Donna
35
Cost
1
2
3
4
5
Quantity of books
BA 210 Lesson I.5 Surplus and Efficiency
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Producer Surplus
Producer Surplus in the Used Textbook Market
Price of book
S
$45
Engelbert
35
Donna
Price = $30
Carlos’s
producer
surplus
Betty’s
producer
Andrew’s surplus
producer
surplus
30
25
Carlos
Betty
15
5
0
Andrew
1
2
3
4
5
Quantity of books
BA 210 Lesson I.5 Surplus and Efficiency
12
Producer Surplus
Producer Surplus in continuous units, or large numbers …
Price of wheat (per bushel)
S
$5
Price = $5
Producer
surplus
0
The total producer
surplus from sales of a
good at a given price is
the area above the
supply curve but below
that price.
1 million
Quantity of wheat (bushels)
BA 210 Lesson I.5 Surplus and Efficiency
13
How Price affects Producer Surplus

When the price of a good rises, producer surplus increases in
two ways:
• 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
by the higher price.
BA 210 Lesson I.5 Surplus and Efficiency
14
How Price affects Producer Surplus
See the change in continuous units, or large numbers …
Price of wheat (per
bushel)
Increase in
producer surplus to
original sellers
Producer
surplus gained
by new sellers
S
$7
5
0
1 million
1.5 million
Quantity of wheat (bushels)
BA 210 Lesson I.5 Surplus and Efficiency
15
Who Cares about Total Surplus?
• The total surplus generated in a market is the total net gain to
consumers and producers from trading in the market. It is the
sum of the producer and the consumer surplus.
• Total surplus from trade can measure a nation’s prosperity
more accurately than GDP (gross domestic product) or total
output.
• The concepts of consumer surplus and producer surplus can
also help us understand why markets are an effective way to
organize economic activity.
BA 210 Lesson I.5 Surplus and Efficiency
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Who Cares about Total Surplus?
Total Surplus
Price of book
S
Equilibrium
price
Consumer
surplus
$30
E
Producer
surplus
D
0
1,000
Quantity of books
Equilibrium quantity
BA 210 Lesson I.5 Surplus and Efficiency
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Who Cares about Total Surplus?
Consumer Surplus, Producer Surplus, and the Gains from Trade
 The previous graph shows that both consumers and producers are
better off because there is a market in this good; that is, there are
gains from trade.
 These gains from trade are the reason everyone is better off
participating in a market economy than they would be if each
individual tried to be self-sufficient.
 But are we as well off as we could be? This brings us to the
question of the optimality or efficiency of markets.
BA 210 Lesson I.5 Surplus and Efficiency
18
Optimality of Competitive Markets
 Claim: The maximum possible total surplus is achieved at
market equilibrium.
 The market equilibrium allocates the consumption of the good
among potential consumers and sales of the good among
potential sellers in a way that achieves the highest possible
gain to society.
 By comparing the total surplus generated by the consumption
and production choices in the market equilibrium to the
surplus generated by a different set of production and
consumption choices, we can show that any change from the
market equilibrium reduces total surplus.
BA 210 Lesson I.5 Surplus and Efficiency
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Optimality of Competitive Markets
Three ways the government tries to increase total surplus
1. Reallocate consumption among consumers. For example,
President Clinton or President Obama wanting to equate
medical care between rich and poor consumers.
2. Reallocate sales among sellers. For example, affirmative
action setting aside government contracts based on the gender
or race of sellers.
3. Change the quantity traded. For example, keeping marijuana
illegal.
BA 210 Lesson I.5 Surplus and Efficiency
20
Optimality of Competitive Markets
Price of book
Loss in consumer
surplus if the book is
taken from Ana and
given to Bob
S
A
$35
E
30
B
25
D
0
1,000
BA 210 Lesson I.5 Surplus and Efficiency
Quantity of books
21
Optimality of Competitive Markets
Price of book
S
Y
$35
E
30
X
Loss in producer surplus
if Yvonne is made to sell
the book instead of Xavier
25
D
0
1,000
Quantity of books
BA 210 Lesson I.5 Surplus and Efficiency
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Optimality of Competitive Markets
Price of
book
$35
Loss in total surplus
if the transaction
between Ana and
Xavier is prevented
A
25
Y
Loss in total surplus if the
transaction between Yvone
and Bob is forced
E
30
S
X
B
D
0
1,000
Quantity of books
BA 210 Lesson I.5 Surplus and Efficiency
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Optimality of Competitive Markets
Competitive Markets for any Good
1. Allocates consumption of the good to the potential buyers who
value it the most, as indicated by the fact that they have the
highest willingness to pay.
2. Allocates sales to the potential sellers who most value the right
to sell the good, as indicated by the fact that they have the
lowest cost.
3. Ensures that every consumer who makes a purchase values the
good more than every seller who makes a sale, so that all
transactions are mutually beneficial.
4. Ensures that every potential buyer who doesn’t make a
purchase values the good less than every potential seller who
doesn’t make a sale, so that no mutually beneficial transactions
are missed.
BA 210 Lesson I.5 Surplus and Efficiency
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Optimality of Competitive Markets



Efficiency and total-surplus maximization in competitive
markets come in two ways: property rights and the role of
prices as economic signals.
Property rights are the rights of owners of valuable items,
whether resources or goods, to use or sell those items as they
choose.
An economic signal is any piece of information that helps
people make better economic decisions.
BA 210 Lesson I.5 Surplus and Efficiency
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Optimality of Competitive Markets
A Caveat

It’s important to realize that although the market equilibrium
maximizes the total surplus, this does not mean that it is the
best outcome for every individual consumer and producer.

For instance, a price floor that kept the price up would benefit
some sellers.

But in the market equilibrium there is no way to make some
people better off without making others worse off - and that’s
the definition of efficiency.
BA 210 Lesson I.5 Surplus and Efficiency
26
Inefficiency from Market Failure
A Few Words of Caution
 A market or an economy is inefficient if there are missed
opportunities: some people could be made better off without
making other people worse off.
 Under certain conditions, market failure occurs and the market
produces an inefficient outcome.
 The three principal sources are:
 attempts to capture more resources that produce
inefficiencies, such as monopolizing a commodity.
 side effects from certain transactions, such as smoking.
 problems in the nature of the goods themselves, such as
parks.
BA 210 Lesson I.5 Surplus and Efficiency
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Controversy: Affirmative Action
Controversy: Affirmative Action
BA 210 Lesson I.3 Trade
28
Controversy: Affirmative Action
Affirmative action refers to policies that take race, ethnicity,
physical disabilities, military career, or sex into consideration in
an attempt to promote increased opportunities or increased
ethnicity or other forms of diversity. The focus of such policies
ranges from employment and education to public contracting and
health programs. The force towards affirmative action is twofold:
to maximize diversity in all levels of society, along with its
presumed benefits, and to redress perceived disadvantages due to
overt, institutional, or involuntary discrimination. Opponents
argue that it promotes reverse discrimination.
BA 210 Lesson I.3 Trade
29
Controversy: Affirmative Action
Question: Use demand and supply curves to show the following
surplus looses from affirmative action programs designed to help
women:
 the lost consumer surplus if affirmative action programs cause
Pepperdine University to accept one more woman and one less
man.
 the lost producer surplus if affirmative action programs cause
the state of California to hire one more woman and one less
man.
 the lost total surplus if affirmative action programs cause Kaiser
Permanente to offer health care to one more woman.
BA 210 Lesson I.3 Trade
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Controversy: Affirmative Action
Answer: The lost consumer surplus if Pepperdine University
accepts one more woman and one less man.
Loss in consumer
surplus if education
is taken from Albert
and given to Betty
S
A
$35
E
30
B
25
D
0
1,000
Quantity of Pepperdine Students
BA 210 Lesson I.5 Surplus and Efficiency
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Controversy: Affirmative Action
The lost producer surplus if the state of California hires one more
woman and one less man.
S
Y
$35
E
30
X
Loss in producer surplus
if Yvonne is made to sell
labor instead of Xavier
25
D
0
1,000
Quantity of labor
BA 210 Lesson I.5 Surplus and Efficiency
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Controversy: Affirmative Action
The lost total surplus if Kaiser Permanente offers health care to
one more woman.
S
K
$35
30
Loss in total surplus if the
transaction between
Kaiser and Betty is forced
E
25
B
D
0
1,000
Quantity of health care enrollment
BA 210 Lesson I.5 Surplus and Efficiency
33
Summary
1.
2.
3.
The willingness to pay of each individual consumer
determines the demand curve. When price is less than or
equal to the willingness to pay, the potential consumer
purchases the good. The difference between willingness to
pay and price is the net gain to the consumer, the individual
consumer surplus.
Total consumer surplus in a market, the sum of all individual
consumer surpluses in a market. A rise in the price of a good
reduces consumer surplus; a fall in the price increases
consumer surplus.
The cost of each potential producer, the lowest price at which
he or she is willing to supply a unit of that good, determines
the supply curve. If the price of a good is above a producer’s
cost, a sale generates a net gain to the producer, known as the
individual producer surplus.
BA 210 Lesson I.5 Surplus and Efficiency
34
Summary
4.
5.
6.
7.
Total producer surplus in a market, the sum of the individual
producer surpluses in a market, is equal to the area above the
market supply curve but below the price.
Total surplus, the total gain to society from the production
and consumption of a good, is the sum of consumer and
producer surplus.
Usually, markets are efficient and achieve the maximum total
surplus. Government intervention in a market that reduces
efficiency but increases equity can also be a valid choice by
society.
The keys to the efficiency of a market economy are property
rights and the operation of prices as economic signals. Under
certain conditions, market failure occurs, making a market
inefficient.
BA 210 Lesson I.5 Surplus and Efficiency
35
Review Questions
Review Questions
 You should try to answer some of the following questions
before the next class.
 You will not turn in your answers, but students may request
to discuss their answers to begin the next class.
 Your upcoming Exam 1 and cumulative Final Exam will
contain some similar questions, so you should eventually
consider every review question before taking your exams.
BA 210 Lesson I.5 Surplus and Efficiency
36
Review Questions
Follow the link
http://faculty.pepperdine.edu/jburke2/ba210/PowerP1/Set4Answers.pdf
for review questions for Lesson I.5 that practices these skills:
 Compute consumer surplus from willingness to pay, or a demand curve.
 Compute producer surplus from willingness to sell, or a supply curve.
 Describe how supply shifts affect consumer surplus.
 Describe how demand shifts affect producer surplus.
 Aggregate consumer surplus to determine willingness to pay for all-you-canconsume (food or rides).
 Show how producer surplus is an essential incentive for production.
BA 210 Lesson I.5 Surplus and Efficiency
37
BA 210
Introduction to Microeconomics
End of Lesson I.5
BA 210 Lesson I.5 Surplus and Efficiency
38