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A Lecture Presentation
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to accompany
Exploring Economics
Second Edition
by Robert L. Sexton
Copyright © 2002 Thomson Learning, Inc.
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Printed in the United States of America
ISBN 0030342333
Copyright © 2002 by Thomson Learning, Inc.
Chapter 6
Consumer Choice and Welfare
Copyright © 2002 by Thomson Learning, Inc.
6.1 Consumer Behavior


Individuals take action in response to
recognized opportunities to advance
their goals.
This assumption that individuals act to
advance their goals—known as the rule
of rational choice—merely implies that
whatever individuals do is done with a
purpose.
Copyright © 2002 by Thomson Learning, Inc.
6.1 Consumer Behavior


In economics we assume that each
individual seeks to maximize his or her
own well-being or satisfaction.
Economists developed the concept of
utility to allow them to study the relative
levels of satisfaction that consumers get
from the consumption of goods and
services.
Copyright © 2002 by Thomson Learning, Inc.
6.1 Consumer Behavior



Utility varies from individual to individual
depending on specific preferences.
Therefore, it is not possible to compare
the relative satisfactions of different
persons.
Total utility is the total amount of
satisfaction derived from the
consumption of a certain number of
units of a good or service.
Copyright © 2002 by Thomson Learning, Inc.
6.1 Consumer Behavior



Marginal utility is the additional
satisfaction generated by the last unit of
a good that is consumed.
Total utility increases with additional
consumption.
The incremental satisfaction—the
marginal utility—that results from the
consumption of additional units tends to
decline as consumption increases.
Copyright © 2002 by Thomson Learning, Inc.
6.1 Consumer Behavior

This law of diminishing marginal
utility means that each successive unit
of a good that is consumed generates
less additional satisfaction than did the
previous unit.
Copyright © 2002 by Thomson Learning, Inc.
Exhibit 1: Total and Marginal Utility
15
40
Marginal
utility
10
5
0
1
2 3 4
Quantity of Pizza Slices
(per hour)
Copyright © 2002 by Thomson Learning, Inc.
Total Utility
Marginal Utility
(per pizza slice)
20
30
20
Total
utility
10
0
1
2 3 4
Quantity of Pizza Slices
(per hour)
6.1 Consumer Behavior

It follows from the law of diminishing
marginal utility that as a person uses
more and more units of a good to satisfy
a given want, the intensity of the want,
and the utility derived from further
satisfying that want, diminishes.
Copyright © 2002 by Thomson Learning, Inc.
6.2 The Consumer’s Choice

Consumers try to add to their total utility,
so when the marginal utility generated
by the purchase of additional units of
one good drops too low, it can become
rational for the consumer to purchase
other goods rather than to purchase
more of the first good.
Copyright © 2002 by Thomson Learning, Inc.
6.2 The Consumer’s Choice


A rational consumer will avoid making
purchases of any one good beyond the
point at which other goods will yield
greater satisfaction for the amount
spent.
Marginal utility is an important concept
in understanding and predicting
consumer behavior.
Copyright © 2002 by Thomson Learning, Inc.
6.2 The Consumer’s Choice


By comparing the marginal utilities
generated by units of the goods that he
or she desires as well as their prices, a
rational consumer seeks the
combination of goods that maximizes
his or her satisfaction.
When the optimum, utility-maximizing
level of each good has been purchased,
consumers are said to have reached the
point of consumer equilibrium.
Copyright © 2002 by Thomson Learning, Inc.
6.2 The Consumer’s Choice


In order to reach consumer equilibrium,
consumers must allocate their income in
such a way that the ratio of the marginal
utility to the price of the good is equal
for all goods purchased.
When this goal is realized, one dollar’s
worth of additional gasoline will yield the
same marginal utility as one dollar’s
worth of additional bread or apples or
movie tickets or soap.
Copyright © 2002 by Thomson Learning, Inc.
6.2 The Consumer’s Choice

Given a fixed budget, if the marginal
utilities per dollar spent on additional
units of two goods are not the same, the
consumer can increase total satisfaction
by buying more of a good with a higher
marginal utility per dollar and less of
another good with a lower marginal
utility per dollar.
Copyright © 2002 by Thomson Learning, Inc.
6.2 The Consumer’s Choice


Consumers will continue to alter their
purchases to increase their satisfaction
until the ratio of the marginal utility to
the price of each good is equal for all
goods purchased.
The law of demand—buying more of a
good as its price is reduced—reflects
consumer equilibrium where goods are
subject to the law of diminishing
marginal utility.
Copyright © 2002 by Thomson Learning, Inc.
6.2 The Consumer’s Choice

A lower price for a good increases its
marginal utility or satisfaction per dollar,
leading to an increase in the quantity of
that good demanded.
Copyright © 2002 by Thomson Learning, Inc.
6.3 Consumer and Producer Surplus


What a consumer actually pays for a
good is usually less than what she is
willing to pay.
The monetary difference between what
the consumer is willing to pay and what
the consumer actually pays is called
consumer surplus.
Copyright © 2002 by Thomson Learning, Inc.
6.3 Consumer and Producer Surplus

Consumer surplus is shown graphically
as the area under the demand curve
(willingness to pay for the units
consumed) and above the market price
(what must be paid for those units).
Copyright © 2002 by Thomson Learning, Inc.
Price
Exhibit 1: Consumer Surplus
a
P
b
Demand
0
Copyright © 2002 by Thomson Learning, Inc.
Q
Quantity
6.3 Consumer and Producer Surplus

If the consumer buys several units of a
good, the earlier units will have greater
marginal value and therefore create
more consumer surplus because
marginal willingness to pay falls as
greater quantities are consumed in any
period.
Copyright © 2002 by Thomson Learning, Inc.
Price of Iced Tea (per glass)
Exhibit 2: Consumer Surplus for
Iced Tea
$4
$3
Consumer surplus =
$3 + $1 = $4
$2
$1
$1
$ .50
0
Market price
DICED TEA
1
2
3
Quantity of Iced Tea (by glass)
Copyright © 2002 by Thomson Learning, Inc.
6.3 Consumer and Producer Surplus



An increase in supply will lower the
price and increase your consumer
surplus for each of the units you were
already consuming.
A supply increase will also increase
consumer surplus from increased
purchases at the lower price.
Conversely, a decrease in supply will
increase the price and lower the amount
of consumer surplus.
Copyright © 2002 by Thomson Learning, Inc.
Exhibit 3: The Impact of an Increase
in Supply on Consumer Surplus
Gain in consumer surplus
A
from fall in price
S0
Price
S1
B
P0
C
P1
D
0
Copyright © 2002 by Thomson Learning, Inc.
Q0 Q 1
Quantity
6.3 Consumer and Producer Surplus


Producer surplus is the difference
between what a producer is paid for a
good and the seller’s cost for producing
each unit of the good.
Because some units can be produced at
a cost that is lower than the market
price, the seller receives a surplus, or
net benefit, from producing those units.
Copyright © 2002 by Thomson Learning, Inc.
6.3 Consumer and Producer Surplus


Producer surplus for a particular unit is
the difference between the market price
and the seller’s cost of producing that
unit.
Total producer surplus is shown
graphically as the area under the
market price (what was paid for those
units) and above the supply curve (the
total cost, or sum of marginal costs, of
producing those units).
Copyright © 2002 by Thomson Learning, Inc.
Exhibit 4: Producer Surplus
Price
Supply
$5
4
$2
Market
Price
$1
$3
3
2
1
0
1
2
Copyright © 2002 by Thomson Learning, Inc.
3
4
5
Quantity
6.3 Consumer and Producer Surplus



A higher market price due to an
increase in demand will increase total
producer surplus.
Part of the added surplus is due to a
higher price for the quantity already
being produced.
Part is due to the expansion of output
made profitable by the higher price.
Copyright © 2002 by Thomson Learning, Inc.
Exhibit 5: The Impact of an Increase
in Demand on Producer Surplus
S
Price
P1
P0
New Market
Price
Addition to
producer surplus
Old Market
Price
Old
producer
surplus
0
Copyright © 2002 by Thomson Learning, Inc.
Q0
Q1
Quantity
6.3 Consumer and Producer Surplus


With the tools of consumer and
producer surplus, we can better analyze
the total gains from exchange.
The demand curve represents a
collection of maximum prices that
consumers are willing and able to pay
for additional quantities of a good or
service.
Copyright © 2002 by Thomson Learning, Inc.
6.3 Consumer and Producer Surplus



The supply curve represents a
collection of minimum prices that
suppliers require to be willing to supply
additional quantities of that good or
service.
At the market equilibrium, consumers
receive consumer surplus and
producers receive producer surplus.
Both benefit from trading every unit up
to the market equilibrium output.
Copyright © 2002 by Thomson Learning, Inc.
6.3 Consumer and Producer Surplus


Buyers purchase each good, except for
the very last unit, for less than the
maximum amount that they would have
been willing to pay.
Sellers receive more than the minimum
amount they would have been willing to
accept to supply the good.
Copyright © 2002 by Thomson Learning, Inc.
6.3 Consumer and Producer Surplus


Once the equilibrium output is reached
at the equilibrium price, all of the
mutually beneficial trade opportunities
between the suppliers and the
demanders will have taken place.
The sum of consumer and producer
surplus is maximized.
Copyright © 2002 by Thomson Learning, Inc.
6.3 Consumer and Producer Surplus


The total welfare gain to the economy
from trade in a good is the sum of the
consumer and producer surplus
created.
Consumers benefit from additional
amounts of consumer surplus and
producers benefit from additional
amounts of producer surplus.
Copyright © 2002 by Thomson Learning, Inc.
6.3 Consumer and Producer Surplus


Improvements in welfare come from
additions to both consumer and
producer surplus.
In competitive markets, where there are
large numbers of buyers and sellers at
the market equilibrium price and
quantity, the net gains to society are as
large as possible.
Copyright © 2002 by Thomson Learning, Inc.
Exhibit 6: Consumer and Producer Surplus
S
$8
Price
7
6 CS
5
CS
CS
4
3 PS
2
PS
PS
D
1
0
Copyright © 2002 by Thomson Learning, Inc.
1
2
3
4
Quantity
6.4 The Welfare Effects of Taxes
and Price Controls

We can use consumer and producer
surplus to measure the welfare effects
of various government programs, such
as taxes and price controls.
Copyright © 2002 by Thomson Learning, Inc.
Exhibit 1: The Supply and Demand
of a Tax
Supply
Price
PB
Tax
Revenue
T  Q1
Tax
PS
Demand
Q1
Copyright © 2002 by Thomson Learning, Inc.
Q0
Quantity
6.4 The Welfare Effects of Taxes
and Price Controls

Welfare effects refer to the gains and
losses associated with government
intervention.


After a tax is imposed, consumers pay a
higher price and lose the corresponding
amount of consumer surplus as a result.
Producers receive a lower price after tax
and lose the corresponding amount of
producer surplus as a result.
Copyright © 2002 by Thomson Learning, Inc.
6.4 The Welfare Effects of Taxes
and Price Controls


The government gains the amount of
the tax revenue generated, which is
transferred to others in society.
The net loss to society, or deadweight
loss, of a tax is the difference between
the lost consumer and producer surplus
and the tax revenue generated,
represented graphically as the
deadweight loss triangle.
Copyright © 2002 by Thomson Learning, Inc.
Exhibit 2: Welfare Effects of a Tax
Price
PB
a
b
P0
PS
Deadweight S
Loss
TAX
d
c
e
f
D
0
Copyright © 2002 by Thomson Learning, Inc.
Q1
Q0
6.4 The Welfare Effects of Taxes
and Price Controls


The deadweight loss of a tax occurs
because the tax reduces the quantity
exchanged below the original output
level, reducing the size of the total
surplus realized from trade.
The tax distorts market incentives.

The price to buyers is higher than before
the tax, so they consume less, and the
price to sellers is lower than before the tax,
so they produce less.
Copyright © 2002 by Thomson Learning, Inc.
6.4 The Welfare Effects of Taxes
and Price Controls


This leads to deadweight loss, or
market inefficiencies—the waste
associated with not producing the
efficient output.
The size of the deadweight loss from a
tax, as well as how the burdens are
shared between buyers and sellers,
depends on the elasticities of supply
and demand.
Copyright © 2002 by Thomson Learning, Inc.
6.4 The Welfare Effects of Taxes
and Price Controls



Other things equal, the less elastic the
demand curve, the smaller the
deadweight loss.
Similarly, the less elastic the supply
curve, the smaller the deadweight loss.
However, if either the supply or demand
curves become more elastic, the
deadweight loss will be larger because
a given tax will reduce the quantity
exchanged by a greater amount.
Copyright © 2002 by Thomson Learning, Inc.
6.4 The Welfare Effects of Taxes
and Price Controls

That is, the more elastic the curves are,
the greater the change in output and the
larger the deadweight loss.
Copyright © 2002 by Thomson Learning, Inc.
Exhibit 3: Elasticity and Deadweight
Loss
Price
Deadweight loss
is relatively
S
small.
$.50 Tax
D
0
Copyright © 2002 by Thomson Learning, Inc.
Q 1 Q0
Quantity
Exhibit 3: Elasticity and Deadweight
Loss
S
Price
Deadweight loss
is relatively small.
0
Copyright © 2002 by Thomson Learning, Inc.
$.50 Tax
Q1 Q0
Quantity
D
Exhibit 3: Elasticity and Deadweight
Loss
Price
Deadweight loss
is relatively large.
S
$.50 Tax
D
0
Copyright © 2002 by Thomson Learning, Inc.
Q1
Q0
Quantity
6.4 The Welfare Effects of Taxes
and Price Controls

Elasticity differences can help us
understand tax policy.



Those goods that are heavily taxed often
have a relatively inelastic demand curve in
the short run.
This means that the burden falls mainly on
the buyer.
It also means that the deadweight loss to
society is smaller than if the demand curve
was more elastic.
Copyright © 2002 by Thomson Learning, Inc.
6.4 The Welfare Effects of Taxes
and Price Controls


We can see the welfare effects of a
price ceiling by observing the change in
consumer and producer surplus from
the implementation of the price ceiling.
Consumers can now buy at a lower
price, but cannot buy as much as before
(since suppliers will not supply as
much).
Copyright © 2002 by Thomson Learning, Inc.
6.4 The Welfare Effects of Taxes
and Price Controls


Producers lose producer surplus from
the lower imposed ceiling price.
The net loss is the resulting deadweight
loss triangle, just as with a tax.
Copyright © 2002 by Thomson Learning, Inc.
Exhibit 4: Welfare Effects of a Price
Ceiling
Price
P1
P0
PMAX
a
b
d
f
Deadweight
Loss
c
e
S
Price Ceiling
D
0
Copyright © 2002 by Thomson Learning, Inc.
Q1
Q0
Quantity
6.4 The Welfare Effects of Taxes
and Price Controls


We can also use consumer and
producer surplus to see the welfare
effects of a price floor, where the
government buys up the surplus.
Consumers lose consumer surplus due
to the higher price floor, and must also
pay taxes to pay for the buying and
storing of the unsold (to consumers)
output.
Copyright © 2002 by Thomson Learning, Inc.
6.4 The Welfare Effects of Taxes
and Price Controls


Producers gain producer surplus from
the higher prices and greater output
(since the government buys up what is
not sold on the market).
On net, there is a deadweight loss from
the price floor.
Copyright © 2002 by Thomson Learning, Inc.
Exhibit 5: Agricultural Price
Supports
S
Price of Cheese
P
B
$4
C
Surplus the
government
must absorb
$3
0
Copyright © 2002 by Thomson Learning, Inc.
Price
Floor
A
D
QD
QS
Q
Quantity of Cheese
D
Exhibit 6: Welfare Effects of a Price Floor
When Government Buys the Surplus
Deadweight Loss
(c + f + g + h + I)
S
Price
a
P1
b
d
c
P0
h
f
e
0
Copyright © 2002 by Thomson Learning, Inc.
g
Q1
Q0
Quantity
D
i
QS