Topic 4 Consumer and Producer Surplus PDF

EC4101 Topic 4: Consumer and Producer Surplus Learning objectives How much benefit do producers and consumers receive from the existence of a market? How is the welfare of consumers and producers affected by changes in market prices? How are these concepts related to the demand and sup...

EC4101 Topic 4: Consumer and Producer Surplus Learning objectives How much benefit do producers and consumers receive from the existence of a market? How is the welfare of consumers and producers affected by changes in market prices? How are these concepts related to the demand and supply curve? Consumer Surplus Producer Surplus Consumer Surplus and the Demand Curve A consumer’s willingness to pay for a good is the maximum price at which he or she would buy that good Consumer surplus: the difference between market price and what consumers (as individuals or the market) would be willing to pay  The Demand Curve for Used Textbooks Price of book Potential Willingness €59 Julie buyers to pay Julie €59 Dean 45 45 Dean Kate 35 Nick 25 35 Kate Anna 10 25 Nick A consumer’s willingness to pay 10 Anna for a good is the maximum price D 0 1 2 3 4 5 at which he or she would buy Quantity of books that good Willingness to Pay and Consumer Surplus Total consumer surplus is the sum of the individual consumer surpluses of all the buyers of a good The term consumer surplus is often used to refer to both individual and total consumer surplus  Consumer Surplus in the Used Textbook Market Price of book Julie’s consumer surplus: €59-€30=€29 €59 Julie The total consumer surplus is Dean’s consumer surplus: €45-€30=€15 given by the entire shaded area 45 Dean Kate’s consumer surplus: €35-€30=€5 35 Kate 30 Price = €30 i.e. the sum of the individual 25 Nick consumer surpluses of Julie, Dean, and Kate 10 Anna Equal to €29 + €15 + €5 = €49. D 0 1 2 3 4 5 Quantity of books  Consumer Surplus and the Demand Curve Consumer surplus is the area beneath the demand curve and above the price Price of Area of triangle widgets Height 80 Total consumer surplus at a price of €20 ½(base x height) Base ½(80 – 20) × 90 = €2,700 or ½(90) × (80 – 20) = €2,700 20 D 90 Quantity of widgets How Changing Prices Affect Consumer Surplus A fall in the price of a good increases consumer surplus through two channels: 1. A gain to consumers who would have bought at the original price and … 2. A gain to consumers who are persuaded to buy by the lower price. Consumer Surplus and a Fall in the Price of Used Textbooks Price of book Increase in Julie’s consumer surplus €59 Julie Increase in Dean’s consumer surplus 45 Dean Increase in Kate’s 35 Kate consumer surplus 30 Original price = €30 25 Nick 20 New price = €20 Nick’s consumer 10 Anna surplus D 0 1 2 3 4 5 Quantity of books A Fall in the Market Price Increases Consumer Surplus Price of computers Increase in consumer surplus to original €5,000 buyers Consumer surplus gained by new buyers 1,500 D 0 200,000 1 million Quantity of computers Economics in action: When money isn’t enough The key insight we get from the concept of consumer surplus is that purchases yield a net benefit to the consumer. The consumer typically pays a price less than his or her willingness to pay Most of the time we don’t think about the value associated with the right to buy a good During World War II, government officials created a system of rationing goods where coupons gave individuals the right to buy goods at the government-regulated price As a result, illegal markets in meat stamps and gas coupons emerged. Also, criminals began stealing and counterfeiting coupons People who bought ration coupons on the illegal market were paying for the right to get some consumer surplus Producer Surplus and the Supply Curve A potential seller’s cost is the lowest price at which he or she is willing to sell a good Individual producer surplus is the net gain to a seller from selling a good It is equal to the difference between the price received and the seller’s cost Total producer surplus in a market is the sum of the individual producer surpluses of all the sellers of a good  The Supply Curve for Textbooks Price of book S €45 Cengage Potential sellers Cost 35 Pearson Cengage €45 Pearson €35 25 Wiley Wiley €25 McGraw-Hill €15 15 McGraw-Hill Oxford €5 5 Oxford 0 1 2 3 4 5 Quantity of books Producer Surplus in the Textbook Market Price of book S €45 Cengage 35 Pearson 30 Price = €30 25 Wiley’s Wiley producer surplus McGraw-Hill’s 15 McGraw-Hill producer Oxford’s surplus producer 5 Oxford surplus 0 1 2 3 4 5 Quantity of books  Producer Surplus Price of wheat (per bushel) S The total producer surplus from sales of a good at a given price €5 Price = €5 is the area above the supply Producer surplus curve but below that price 0 1 million Quantity of wheat (bushels)  Active learning: Practice Using the following diagram, calculate total producer surplus if the price of oil is $50 per barrel. a) 0 Price b) $45 c) $1,350 d) $2,700 Quantity of Oil (Millions of Barrels per day)  Active learning: Practice If a dinner at Fast Eddy’s tonight sells for $13, what is the value of Fast Eddy’s producer surplus? a. $10 b. $17 c. $20 d. $21 Changes in Producer Surplus When the price of a good rises, producer surplus increases through two channels: 1. The gains of those who would have supplied the good even at the original, lower price and … 2. The gains of those who are induced to supply the good by the higher price A Rise in the Price Increases Producer Surplus Price of wheat (per bushel) Increase in Producer producer surplus to surplus gained S original sellers by new sellers €7 5 0 1 million 1.5 million Quantity of wheat (bushels) Economics in action: When the corn is high In mid-2000s, the US government encouraged the use of petrol that contains a percentage of ethanol in order to fight air pollution and to reduce US dependence on foreign oil US farmland prices doubled nationally in the 2000s, with farmland in soil-rich areas in Iowa and Illinois more than three times the national level One result of the shift to ethanol fuel was a rise in the demand for corn, leading to a surge in corn prices. Corn prices rose from roughly $2 a bushel in 2005 to over $7 a bushel in early 2012 A person who bought a farm in Iowa at this time bought the producer surplus that the farm generated. Higher prices for corn, which raised the producer surplus of Iowa farmers, made Iowa farmland more valuable Putting It Together: Total Surplus The total surplus generated in a market is the total net gain to consumers and producers from trading in the market. It is the sum of the producer and the consumer surplus The concepts of consumer surplus and producer surplus can help us understand why markets are an effective way to organise economic activity.  Total Surplus Price of book S Consumer Equilibrium surplus E €30 price Producer surplus D 0 1,000 Quantity of books Equilibrium quantity Consumer Surplus, Producer Surplus, and the Gains from Trade The previous graph shows that both consumers and producers are better off because there is a market in this good, i.e. there are gains from trade These gains from trade are the reason everyone is better off participating in a market economy than they would be if each individual tried to be self-sufficient Market Equilibrium Maximises Total Surplus 1. It allocates consumption of the good to the potential buyers who value it the most, as indicated by the fact that they have the highest willingness to pay 2. It allocates sales to the potential sellers who most value the right to sell the good, as indicated by the fact that they have the lowest cost 3. It ensures that every consumer who makes a purchase values the good more than every seller who makes a sale, so that all transactions are mutually beneficial 4. It ensures that every potential buyer who doesn’t make a purchase values the good less than every potential seller who doesn’t make a sale, so that no mutually beneficial transactions are missed Economics in action: eBay and efficiency eBay founded in 1995 by a programmer, Pierre Omidyar, as part of a larger personal website in an attempt to create the ‘perfect market’ Company mission is to create the “perfect market” and “to help practically anyone trade practically anything on earth” One of first items sold in 1995 was a broken laser pointer for $14.83 When Omidyar contacted winning bidder to ask if he understood that the laser pointer was broken, the buyer responded that he was a “collector of broken laser pointers”! Economics in action: eBay and efficiency Garage/car boot sales are a way for people to sell items they don’t want to others who have some use for them, to benefit both parties. However, many potential beneficial trades are missed because sellers and buyers may not be in position to meet each other due to factors such as distance eBay provides a way for would-be buyers and would be sellers of unique or used items to find each other even if they don’t live in the same neighbourhood or city The potential gains from trade are evidently large: In 2021, eBay had over 159 million active users, with over $100 billion in goods bought and sold that year Economics in action: eBay and efficiency Equity and efficiency Efficiency is important, but society also cares about equity Sometimes societies choose to have governments intervene in markets to increase equity (even though it reduces efficiency) Why Markets Typically Work So Well Well-functioning markets owe their effectiveness to two powerful features: property rights and the role of prices as economic signals Property rights are the rights of owners of valuable items, whether resources or goods, to dispose of those items as they choose An economic signal is any piece of information that helps people make better economic decisions A few words of caution… Markets aren’t always efficient; sometimes they fail Market power Externalities Information asymmetry Public goods Inefficient: Opportunities are missed. Some people could be made better off without making other people worse off Summary 1. The willingness to pay of each individual consumer determines the demand curve. When price is less than or equal to the willingness to pay, the potential consumer purchases the good. The difference between willingness to pay and price is the net gain to the consumer, the individual consumer surplus 2. Total consumer surplus in a market, the sum of all individual consumer surpluses in a market. A rise in the price of a good reduces consumer surplus; a fall in the price increases consumer surplus 3. The cost of each potential producer, the lowest price at which he or she is willing to supply a unit of that good, determines the supply curve. If the price of a good is above a producer’s cost, a sale generates a net gain to the producer, known as the individual producer surplus Summary 4. Total producer surplus in a market, the sum of the individual producer surpluses in a market, is equal to the area above the market supply curve but below the price. 5. Total surplus, the total gain to society from the production and consumption of a good, is the sum of consumer and producer surplus. 6. Usually, markets are efficient and achieve the maximum total surplus. Government intervention in a market that reduces efficiency but increases equity can also be a valid choice by society. 7. The keys to the efficiency of a market economy are property rights and the operation of prices as economic signals. Under certain conditions, market failure occurs, making a market inefficient.