LECTURE #6: MICROECONOMICSCHAPTER 7

Consumer & Producer Surplus

Market Efficiency

Market Failure

Consumer Surplus

Welfare EconomicsHow the allocation of resources affects economic

well-being

Willingness to PayHow 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

$100

8070

50

Price ofAlbums

The Demand Curve

4

The graph shows the corresponding demand curve. Note that the height of the demand curve reflects buyers’ willingness to pay

0 431 2Quantity of Albums

John’s willingness to pay

Paul’s willingness to pay

George’s willingness to pay

Ringo’s willingness to pay

Demand

$100

8070

50

Price ofAlbums

Measuring Consumer Surplus

5

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.

0 431 2Quantity of Albums

John’s consumersurplus ($20)

Demand

(a) Price = $80

$100

8070

50

Price ofAlbums

0 431 2Quantity of Albums

John’s consumersurplus ($30)

(b) Price = $70

Paul’s consumersurplus ($10)

Total consumersurplus ($40)

Demand

Price and Consumer Surplus

6

Price

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 BCED) and in part because new consumers enter the market at the lower price (area CEF).

0 Quantity

(a) Consumer surplus at price P1 (b) Consumer surplus at price P2

Demand

P1

Q1

Consumersurplus

B

C

A

Price

0 Quantity

Demand

P1

Q1

Initialconsumer

surplus

A

P2

Q2

B

D

C

E

F

Additional consumer surplus to initial

consumers

Consumer surplusto new consumers

Producer Surplus

Willingness to SellCovering your costs is Job #1.

Producer Surplus = Amount Received – Costs

Measuring Producer SurplusHigher prices – increase producer surplus

Surplus = Sell Price minus Cost to Produce

The Supply Curve

8

$900

800

600500

Price ofHouse

Painting

The graph shows the corresponding supply curve. Note that the height of the supply curve reflects sellers’ costs.

0 431 2Quantity of Houses Painted

Mary’s cost

Frida’s cost

Georgia’s cost

Grandma’s cost

Supply

$900

800

600500

Price ofHouse

Painting

Measuring Producer Surplus

9

$900

800

600500

Price ofHouse

Painting

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.

0 431 2Quantity of Houses Painted

Grandma’s producersurplus ($100)

Supply

(a) Price = $600 (b) Price = $800

Supply

Grandma’s producersurplus ($300)

Georgia’s producersurplus ($200)

Total producersurplus ($500)

0 431 2Quantity of Houses Painted

Price and Producer Surplus

10

Price

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 in part because new producers enter the market at the higher price (area CEF).

0 Quantity

(a) Producer surplus at price P1 (b) Producer surplus at price P2

Supply

P1

Q1

Producersurplus

B

C

A

Price

0 Quantity

Supply

P1

Q1

Initialconsumer

surplus

A

P2

Q2

B

D

C

E F

Additional producer surplus to initial

producers

Producer surplusto new producers

Market Efficiency

Three DefinitionsConsumer 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 MarketsAllocate 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 ValueSupply Curve represents value to producers.

Demand curve represents value to consumers

Market Efficiency

Importance of Equilibrium to ValueAt 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 ExternalitiesSide 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)