CONSUMER SURPLUS AND PRODUCER SURPLUS

UNIT 9

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THE PARADOX OF VALUE

Nothing is more useful than water; but it will scarce purchase anything. A diamond on the other hand, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it. How is it that water, which is essential to life, has little value, while diamonds, which are generally used for conspicuous consumption, command an exalted price? The total utility from water consumption does not determine its price, rather waters price determined by its marginal utility, by the usefulness of the last glass of water.

Welfare Economics

Welfare economics is the study of how the allocation of resources affects economic wellbeing.
Buyers and sellers receive benefits from taking part in

the market. The equilibrium in a market maximises the total welfare of buyers and sellers.

Equilibrium in the market results in maximum benefits, and therefore maximum total welfare for both the buyer and the seller.

Welfare Economics

Consumer surplus measures economic welfare from the buyer side. Producer surplus measures economic welfare from the seller side. Willingness to pay is the maximum price that a buyer is willing and able to pay for a good. It measures how much the buyer values the good or service.

Consumer Surplus

What determines how much a buyer would be willing to pay (the maximum price) for a good or service? Answer: The expected benefits received. The market demand curve depicts the various quantities that buyers would be willing and able to purchase at different prices.

Consumer Surplus

Consumer surplus is the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it (i.e. market price of that commodity).

Four Possible Buyers Willingness to Pay

Buyer John Paul George Ringo

Willingness to Pay $100 80 70 50

Four Possible Buyers Willingness to Pay

Price
More than $100 $80 to $100 $70 to $80 $50 to $70 $50 or less None John John, Paul John, Paul, George Ringo

Buyer

Quantity Demanded
0 1 2 3 4

Measuring Consumer Surplus with the Demand Curve

Price of Album $100 Johns consumer surplus ($30) 80 70 50 Total consumer surplus ($40) Pauls consumer surplus ($10)

Quantity of Albums

Measuring Consumer Surplus with the Demand Curve

Price of Album $90 Johns consumer surplus ($30) 80 70 50 Total consumer surplus ($40) Demand Pauls consumer surplus ($10)

Quantity of Albums

Consumer Surplus and Price

Consumer surplus is the area below the demand curve and above the market price.
A lower market price will increase consumer

surplus. A higher market price will reduce consumer surplus.

How the Price Affects Consumer Surplus

Price

Demand

Q1

Q2

Quantity

How the Price Affects Consumer Surplus

Price A

Initial consumer surplus

P1

Demand

Q1

Q2

Quantity

How the Price Affects Consumer Surplus

Price A

Initial consumer surplus

P1

Consumer surplus to new consumers F

P2

Additional consumer surplus to initial consumers

Demand

Q1

Q2

Quantity

Producer Surplus

Market Supply
Depicts the various quantities that suppliers

would be willing and able to sell at different prices. May be viewed as a measure of supplier costs, that is, the opportunity cost of supplying various quantities of the good.

Producer Surplus

Market Supply
The marginal opportunity cost of production

increases as market output expands. Because a producers cost is the lowest price he or she will accept, cost is a measure of his or her willingness to sell.

Producer Surplus
Producer surplus is the amount a seller is paid minus the cost of production. It measures the benefit to sellers of participating in a market.

The willingness of Four Possible Sellers

Seller Mary Louise Georgia Grandma

Willing to sell on price $900 800 600 500

Supply Schedule for the Four Possible Sellers

Price
$900 or more $800 to $900 $600 to $800 $500 to $600 Less than $500

Sellers
Mary, Louise, Georgia, Grandma Louise, Georgia, Grandma Georgia, Grandma Grandma none

Quantity Supplied
4 3 2 1 0

Measuring Producer Surplus with the Supply Curve

Price of House Painting Total producer surplus ($500)

Supply

$900 800

600 500

Georgias producer surplus ($200)

Grandmas producer surplus ($300)

Quantity of Houses Painted

How Price Affects Producer Surplus

Price Supply

P1

B
Initial producer surplus C

A 0 Q1 Q2 Quantity

How Price Affects Producer Surplus

Price Additional producer surplus to initial producers D E F Supply

P2 P1

B
Initial producer surplus C Producer surplus to new producers

A 0 Q1 Q2 Quantity

Market Efficiency

Where there is perfect competition and no externalities, the economic well-being of a society is measured as the sum of consumer surplus and producer surplus. Market efficiency is attained when the allocation of resources maximises total surplus.

Consumer and Producer Surplus in the Market Equilibrium

Price

Consumer Surplus
Supply

Equilibrium price

Producer Surplus

Demand

Equilibrium quantity

Quantity

Market Efficiency: Observations

Free markets allocate the supply of goods to the buyers who value them most highly. Free markets allocate the demand for goods to the sellers who can produce them at least cost.

Market Efficiency: Observations

Free markets produce the quantity of goods that maximises the sum of consumer and producer surplus. In a free market system the many buyers and sellers are motivated by self-interest.
A process of coordination and communication

takes place so that buyers and sellers are directed to the most efficient outcome.

As if by an invisible hand, the free market system reaches efficiency.

Market Failure: Market Power

If a market system is not the one of perfect competition, market power may result.
Market power is the ability of one buyer or

seller to control market price. Market power can cause markets inefficient, and thus fail.

to

be

Market Failure: Externalities

Externalities are created when a market outcome affects individuals other than buyers and sellers in that market.
Externalities are the benefits or costs imposed

by a third party who is not the consumer or the producer. Externalities cause markets to be inefficient, and thus fail.

Conclusion

Consumer and producer surplus measures the benefits of buyers and sellers from participating in the market. Consumer surplus equals buyers willingness to pay for a good minus the amount they actually pay for it. Producer surplus equals the amount sellers willing to receive in exchange of their goods minus actual price they receive for their products.

Conclusion

An allocation of resources that maximises the sum of consumer and producer surplus is said to be efficient. Policy-makers are concerned with efficiency. Market power and externalities can cause markets to be inefficient and to fail.

Exercise
Buyers Willingness to pay Alice $800 Bob $600 Carel $500 John $400 Show each comers surplus by a diagram, if market price set at $500. What would be the total consumer surplus?
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Exercise
Producers Willingness to sell Ali $90 Baber $70 Lizna $60 Sasi $50 Show each producers surplus by a diagram, if market price set at $50. What would be the total producers surplus?
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