LECTURE #6: MICROECONOMICS
CHAPTER 7
Consumer & Producer Surplus
Market Efficiency
Market Failure
Consumer Surplus
Welfare Economics
How the allocation of resources affects economic
well-being
Willingness to Pay
How much are you willing to pay to acquire a good?
If you pay less than the amount you were willing to
pay – you have a surplus.
The same principle applies in an auction market.
Consumer Surplus
Lower prices lead to consumer surpluses; e.g.
Wal-Mart "Always low prices…"
Consumer surplus as a measure of "well being"
Economic rationality: Seeking to maximize the
surplus
The Demand Curve
Price of
Albums
John’s willingness to pay
$100
Paul’s willingness to pay
80
70
George’s willingness to pay
Ringo’s willingness to pay
50
Demand
0
1
2
3
Quantity of Albums
4
The graph shows the corresponding demand curve. Note that the
height of the demand curve reflects buyers’ willingness to pay
4
Measuring Consumer Surplus
(a) Price = $80
Price of
Albums
John’s consumer
surplus ($20)
$100
(b) Price = $70
Price of
Albums
John’s consumer
surplus ($30)
$100
80
70
80
70
50
50
Paul’s consumer
surplus ($10)
Total consumer
surplus ($40)
Demand
Demand
0
1
2
3
4
Quantity of Albums
0
1
2
3
4
Quantity of Albums
In panel (a), the price of the good is $80, and the consumer surplus is $20. In
panel (b), the price of the good is $70, and the consumer surplus is $40.
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Price and Consumer Surplus
(b) Consumer surplus at price P2
(a) Consumer surplus at price P1
Price
Price
A
A
Consumer
surplus
P1
C
P1
Initial
consumer
surplus
Additional consumer
surplus to initial
consumers
C
B
B
F
P2
Demand
0
Consumer surplus
to new consumers
Q1
Quantity
D
0
Demand
E
Q1
Q2
Quantity
In panel (a), the price is P1, the quantity demanded is Q1, and consumer surplus equals the area of
the triangle ABC. When the price falls from P1 to P2, as in panel (b), the quantity demanded rises
from Q1 to Q2, and the consumer surplus rises to the area of the triangle ADF. The increase in
consumer surplus (area BCFD) occurs in part because existing consumers now pay less (area
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BCED) and in part because new consumers enter the market at the lower price (area CEF).
Producer Surplus
Willingness to Sell
Covering your costs is Job #1.
Producer Surplus = Amount Received – Costs
Measuring Producer Surplus
Higher prices – increase producer surplus
Surplus = Sell Price minus Cost to Produce
The Supply Curve
Price of
House
Painting
Supply
$900
800
Mary’s cost
Frida’s cost
600
500
Georgia’s cost
Grandma’s cost
0
1
2
3
4
Quantity of Houses Painted
The graph shows the corresponding supply curve. Note that the
height of the supply curve reflects sellers’ costs.
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Measuring Producer Surplus
Price of
House
Painting
(a) Price = $600
Supply
Price of
House
Painting
$900
800
$900
800
600
500
600
500
Grandma’s producer
surplus ($100)
(b) Price = $800
Supply
Total producer
surplus ($500)
Georgia’s producer
surplus ($200)
Grandma’s producer
surplus ($300)
0
1
2
3
4
Quantity of Houses Painted
0
1
2
3
4
Quantity of Houses Painted
In panel (a), the price of the good is $600, and the producer surplus is $100.
In panel (b), the price of the good is $800, and the producer surplus is $500.
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Price and Producer Surplus
(b) Producer surplus at price P2
(a) Producer surplus at price P1
Price
Price
P2
P1
B
Producer
surplus
P1
C
D
E
F
Producer surplus
to new producers
B
Initial
consumer
surplus
A
0
Supply
Additional producer
surplus to initial
producers
Supply
C
A
Q1
Quantity
0
Q1
Q2 Quantity
In panel (a), the price is P1, the quantity supplied is Q1, and producer surplus equals the area of the
triangle ABC. When the price rises from P1 to P2, as in panel (b), the quantity supplied rises from Q1
to Q2, and the producer surplus rises to the area of the triangle ADF. The increase in producer
surplus (area BCFD) occurs in part because existing producers now receive more(area BCED) and
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in part because new producers enter the market at the higher price (area CEF).
Market Efficiency
Three Definitions
Consumer Surplus = Value Received – Amount Paid
Producer Surplus = Amount Received – Cost to seller
Total Surplus = C.S. + P.S.
When T.S. maximizes, markets are efficient.
A market in equilibrium maximizes T.S. (See Figure 7)
Problem of Equity arises if surpluses are not evenly
distributed
Market Efficiency
Allocation of Resources in Fee Markets
Allocate supply of goods to buyers that value them most
highly.
Allocate demand for goods to sellers than produce at the least
cost.
Free markets produce the quantity of goods that maximizes
CS and PS.
Supply and Demand Curves as measures of Value
Supply Curve represents value to producers.
Demand curve represents value to consumers
Market Efficiency
Importance of Equilibrium to Value
At quantities below equilibrium, consumer value is
greater than producer cost.
At quantities above equilibrium, cost to sellers is
greater than value to buyers.
Market Efficiency And Market Failure
Market Efficiency assumes perfectly competitive
markets.
Market Efficiency reduced if P or C has market power –
ability to influence price.
Impact of Externalities
Side effects that impair total welfare; e.g. pollution
Failure to monitor and protect property rights; e.g. patents and
copyrights
Market Failure = when resources inefficiently allocated
Homework
Questions for Review: 1, 2, 4, 5 (4Th Ed – same)
Problems and Applications: 3, 4, 5 (part a, b)
4Th ED: 2, 3, 4 (part a, b)