Welfare Economics
Consumer Surplus and Producer
Surplus
Revisiting The Market Equilibrium
• The theory of supply and demand shows how
markets allocate scarce resources among
competing needs.
• But are the equilibrium price and the
equilibrium quantity the right price and the
right quantity from society’s point of view?
• This question takes us into welfare economics.
2
Welfare Economics
• Welfare economics is the study of how the
allocation of resources affects economic wellbeing
• It shows that:
– Both buyers and sellers receive benefits from
taking part in the market
– The equilibrium outcome in the theory of supply
and demand maximizes the total welfare of buyers
and sellers
3
Two main concepts
• When buyers and sellers trade willingly, it must
be because they expect to benefit
• Consumer surplus measures economic welfare
of the buyers.
• Producer surplus measures economic welfare
of the sellers.
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CONSUMER SURPLUS
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Willingness to pay
• To define consumer surplus we first need to
define “willingness to pay.”
• Willingness to pay is the maximum amount
that a buyer will pay for a good.
• It measures how much the buyer values the
good.
6
Willingness to pay: background
• Assume there is a commodity such that every
additional unit of it increases a consumer’s
happiness by the same amount
– In other words, the consumption of additional units of
this commodity induces neither boredom nor
addiction
– Possible examples: potato chips? candy?
• Then the consumer’s willingness to pay for a
product is a good measure of the happiness that
he or she gets from it
7
Willingness to pay: background
• Suppose a bag of potato chips provides a fixed
amount of happiness
• If your willingness to pay is
– 4 bags of potato chips for a shirt, and
– 2 bags of potato chips for a cup of coffee, then
– one can safely say that the shirt makes you twice
as happy as the cup of coffee
• So, your willingness to pay for a commodity is
a good measure of how much you like it
8
Willingness to pay: background
• If the dollar price of a bag of potato chips is
known, willingness to pay in the example
above can also be expressed in dollars
9
Willingness to pay: background
• Another example:
– if you are willing to pay $15 for a shirt, and
– if a bag of potato chips
• always gives you 3 “haps” of happiness, and
• sells at the price of $0.50 each, then
– the shirt gives you 90 “haps” of happiness.
10
Willingness to pay: background
• In other words, your willingness to pay for the
shirt is
– a monetary measure of the happiness you get
from the shirt, and
– it is proportional to the happiness you get from
the shirt, as measured in “haps”
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Table 1 Four Possible Buyers’ Willingness to Pay
For a mint-condition
recording of Elvis
Presley’s first album
I will illustrate consumer surplus through this extended example.
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Consumer Surplus
• Consumer surplus is the buyer’s willingness to pay for
a good minus the amount the buyer actually pays for
it.
– Example: If the Elvis album’s price is $75…
Buyer
Willingness to Pay
Consumer
Surplus
Buy?
John
100
25
Yes
Paul
80
5
Yes
George
Ringo
70
50
-5
-25
No
No
13
Market Demand
• The market demand shows the quantities
demanded by buyers at different prices.
• We can use the willingness-to-pay numbers to
calculate the market demand
– See the next slide
14
The Demand Schedule
Buyer
Willingness
to Pay
John
100
Paul
80
George 70
Ringo
50
15
Figure 1 The Demand Curve
Price of
Album
Buyer
Willingness to Pay
John
100
Paul
80
George 70
John’s willingness to pay
$100
Ringo
Paul’s willingness to pay
80
George’s willingness to pay
70
Ringo’s willingness to pay
50
Demand
0
50
1
2
3
4
The height of the
demand curve at any
quantity shows the
willingness to pay of
whoever bought the
last unit.
Quantity of
Albums
16
Copyright©2003 Southwestern/Thomson Learning
Area of a Rectangle
Area = Width × Height
Height
Width
17
Figure 2 Measuring Consumer Surplus with the
Demand Curve
Buyer
Willingness
(b) Price = $70.01
Price of
Album
$100
Buy?
to Pay
Consumer
Surplus
John
100
30
Yes
Paul
80
10
Yes
George
70
0
No
Ringo
50
-20
No
1. The area under the demand
curve measures the total
willingness to pay for the
quantity demanded.
80
70
50
2. It is also the maximum
willingness to pay that could
be generated from that
quantity.
Demand
0
John’s willingness to pay
1
4 Quantity of
Albums
Paul’s willingness to pay
2
3
20
Interpersonal comparability
• We just saw
– that the total area under the demand curve is
$180, and
– that is also the total willingness to pay of John and
Paul
• But can we say it is the total happiness of John
and Paul?
21
Interpersonal comparability
• Yes,
– if there is a commodity—say, a bag of potato chips—that
provides an unchanging amount of happiness to the
consumer, and
– if John’s happiness and Paul’s happiness are comparable,
and
– if both John and Paul get the same happiness from a bag
of potato chips
• That’s a lot of if’s!
• But we will make these simplifying assumption anyway
– Not just for John and Paul, but for everybody
22
Utilitarianism
• The idea that
– the happiness of an individual can be measured
numerically,
– the happiness of a group of people can be measured
numerically,
– the happiness of a group of people is simply the sum of
the numbers representing the happiness of the individual
members of the group, and that
– social policy should seek to maximize the total happiness
of society,
– is called utilitarianism
• Welfare analysis in this course takes utilitarianism as
its guiding philosophy
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The market and the planner
• Suppose the government has two
copies of the Elvis album. The
government’s goal is to give them to
two of the four guys so as to generate
the maximum happiness.
• Who will get the government’s copies?
• Obviously, John and Paul, same as in
the market outcome we saw before.
• So, the market does the best that the
government could have done
Price = $70
Buyer
Willingness
to Pay
John
100
Paul
80
George
70
Ringo
50
24
Willingness to Pay from the Demand Curve
Price
A
P1
B
C
The area under the demand
curve measures the total
willingness to pay of the
consumers who bought Q1 units.
It also measures the maximum
willingness to pay that could be
obtained from Q1 units
Demand
0
Q1
Quantity
25
Using the demand curve to measure
willingness to pay
• In general, the area under the demand curve
up to the quantity demanded is a graphical
measure of the total willingness to pay of the
buyers.
• It is also the maximum willingness to pay that
can be obtained from that quantity
– That is, the government could not give away that
quantity in a way that generates higher
willingness to pay.
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Figure 3 How the Price Affects Consumer Surplus
(a) Consumer Surplus at Price P
Price
A
Consumer Surplus (ABC) +
Total Payment (OBCQ1) =
Willingness to Pay (OACQ1)
Consumer
surplus
P1
B
C
Total
Payment
0
Demand
Q1
Quantity
30
Using the Demand Curve to Measure
Consumer Surplus
• In general, the area below the demand curve
and above the price measures the consumer
surplus.
31
Figure 3 How the Price Affects Consumer Surplus
(b) Consumer Surplus at Price P
Price
A
Initial
consumer
surplus
P1
P2
0
C
B
Consumer surplus
to new consumers
F
D
E
Additional consumer
surplus to initial
consumers
Q1
Demand
Q2
Quantity
32
Shifts in Demand
• We know that the demand curve can shift, for
reasons such as
– a change in tastes, and
– a change in the prices of related goods
• Given that the demand for a product can shift
as a result of a change in the price of a related
good, does it make sense to say that the area
under the demand curve measures the
happiness consumers get from the product?
33
Shifts in Demand
• Continued from the previous slide
• Yes!
– Keep in mind that the area under the demand curve is a monetary
measure of the happiness obtained by buyers
– The objective or psychological happiness obtained from a shirt may be
unchanged even if the monetary willingness to pay for the shirt
changes, perhaps because of a change in the price of a related good
• In an earlier slide, a bag of potato chips was assumed to always
provide 3 “haps” of happiness, and sold at a price of $0.50.
Consequently, consumers were wiling to pay $15 for a shirt that
provided 90 “haps” of happiness.
• It follows that if the price of a bag of potato chips rises to $1,
consumers would then be willing to pay $30 for the same shirt,
leading to an upward shift in the demand curve for shirts.
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PRODUCER SURPLUS
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Producer Surplus
• Producer surplus is the amount a seller is paid
for a good minus the seller’s cost.
• It measures the net benefit to sellers
• It is almost but not quite the same as profit.
36
Cost of production
• The cost of production is the market value of
all resources used in production
– By all, I do mean all.
– Even if some resources used in production were
obtained for free, their market value must be
included in cost.
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Table 2 The Cost of Painting a House for Four
Possible Sellers
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Costs → Supply
• The supply of house painting services shows
the quantity of house painting services
supplied at all possible prices
• The cost numbers in the previous slide can be
used to calculate supply of house painting
services
39
Costs → Supply
Seller
Cost ($)
Mary
900
Frida
800
Georgia
600
Grandma 500
40
Figure 4 The Supply Schedule and the Supply Curve
The height of the supply curve
at any quantity shows the
production cost to whoever
produces the last unit.
Seller
Cost ($)
Mary
900
Frida
800
Georgia
600
Grandma 500
41
Producer Surplus
• Producer surplus is the amount a seller is paid minus
the seller’s cost
– Example: If the going price for getting a house painted is
$700 we get the following table.
Seller
Cost ($) Producer
Surplus
Sell?
Mary
900
-200
No
Frida
800
-100
No
100
200
Yes
Yes
Georgia 600
Grandma 500
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Using the Supply Curve to Measure
Producer Surplus
• The area below the price and above the supply
curve measures the producer surplus.
43
Figure 5 Measuring Producer Surplus with the Supply
Curve
(b) Price = $799.99
Price of
House
Painting
Supply
1. The area under
the supply curve is
the cost of the
quantity supplied
2. It is also the
lowest cost for that
quantity
$900
800
600
500
0
1
Grandma’s cost
Georgia’s cost
2
3
Seller
Cost ($) Producer
Surplus
Sell?
Mary
900
-100
No
Frida
800
0
No
Georgia
600
200
Yes
Grandma 500
300
Yes
4
Quantity of
Houses Painted
48
Is there a better alternative to the
market system?
• If the government had to get two
houses painted, who would get the
job?
• Grandma and Georgia, of course.
• And, as we just saw, that’s exactly
what happens in the market
outcome.
• So, the market achieves the best
that the government could have
achieved
Seller
Cost ($)
Mary
900
Frida
800
Georgia
600
Grandma 500
49
Figure 5 Measuring Producer Surplus with the Supply
Curve
1. The rectangular
(b) Price = $800
Price of
House
Painting
$900
area under the price
and up to the
quantity supplied is
Supply the Total Revenue.
Total
producer
surplus ($500)
2. The area under the
price and above the
supply is the
Producer Surplus.
800
Seller
Cost ($) Producer
Georgia’s producer
Surplus
surplus ($200)
Mary
900
-100
600
500
Grandma’s producer
surplus ($300)
0
1
2
3
Sell?
No
Frida
800
0
No
Georgia
600
200
Yes
Grandma 500
300
Yes
4
Quantity of
Houses Painted
50
Figure 6 How the Price Affects Producer Surplus
(a) Producer Surplus at Price P
Price
Supply
P1
B
Producer
surplus
A
0
C
Total Revenue (OBCQ1) =
Production Cost (OACQ1) +
Producer Surplus (ABC)
Production
Cost
Q1
Quantity
51
Figure 6 How the Price Affects Producer Surplus
(b) Producer Surplus at Price P
Price
Supply
Additional producer
surplus to initial
producers
P2
P1
D
E
F
B
Initial
producer
surplus
C
Producer surplus
to new producers
A
0
Q1
Q2
Quantity
52
Figure 7 Consumer and Producer Surplus in the
Market Equilibrium
Price A
D
Supply
Consumer
surplus
Equilibrium
price
E
Producer
surplus
B
Demand
C
0
Equilibrium
quantity
Quantity
53