Econ 101: Principles of Microeconomics Chapter 4: Consumer and - PDF document

Econ 101: Principles of Microeconomics Chapter 4: Consumer and Producer Surplus Fall 2010 Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 1 / 32 Outline 1 Consumer Surplus and the Demand Curve 2 Producer Surplus and the Supply Curve 3 Total Surplus and the Gains from Trade Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 2 / 32

Consumer and Producer Surplus We’ve already talked about the notion of efficiency, noting that the market usually lead to efficient outcomes (Principle #8). We’ve also noted that that there are gains from trade through specialization (Principle #5). Some natural questions we might ask are: Is there a way to measure (i.e., quantify) the gains from trade? 1 Similarly, when there are inefficiencies in the market (either intentional, 2 as a means of achieving equity, or unintentional, due to market failure or intervention in the market), can we measure the corresponding loss? In this chapter, we introduce the notions of consumer surplus and producer surplus to answer these questions. Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 3 / 32 Consumer Surplus and the Demand Curve Marginal Willingness-to-Pay The demand curve provides a graphical depiction of the quantity demanded of a good at various price levels. Another useful way of looking at the demand curve is as measuring the consumer’s marginal willingness-to-pay (or MWTP) for a good. The MWTP is the maximum price the individual would be willing to pay for the next unit of the good or service. Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 4 / 32

Consumer Surplus and the Demand Curve An Example: Joseph’s MWTP for Shoes Suppose we know that Joseph has the following MWTP for shoes Quantity Joseph’s MWTP 1 $120 2 $100 3 $80 4 $60 Notice that the MWTP declines as the quantity goes up. Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 5 / 32 Consumer Surplus and the Demand Curve Joseph’s MWTP Graphically The MWTP generates Joseph’s demand curve. Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 6 / 32

Consumer Surplus and the Demand Curve Consumer Surplus for the Individual So, what is the net gain to Joseph if he buys 2 pairs of shoes at $90 per pair? Well, he would have been willing to pay $120 for the first pair, but only paid $90, for a net gain (or surplus) of $120 - $90 = $30. For the second pair, his surplus is smaller, since he is only WTP $100 for the second pair of shoes. In this case, the surplus is $100 - $90 = $10. Joseph’s total consumer surplus is $30 + $10 = $40 Graphically, this total surplus is the area above the market price and below the individual’s demand curve. Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 7 / 32 Consumer Surplus and the Demand Curve Joseph’s Consumer Surplus Graphically Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 8 / 32

Consumer Surplus and the Demand Curve More than One Consumer Suppose we now have several consumers in the market for shoes, with MWTP’s Price Joseph Michael John Mary 1 120 110 90 85 2 100 70 65 75 3 80 30 40 65 4 60 0 15 25 Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 9 / 32 Consumer Surplus and the Demand Curve Individual MWTP Graphs Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 10 / 32

Consumer Surplus and the Demand Curve The Market Demand for Shoes The market will naturally organize itself from highest to lowest MWTP Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 11 / 32 Consumer Surplus and the Demand Curve What would be the Consumer Surplus with P=70? Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 12 / 32

Consumer Surplus and the Demand Curve Consumer Surplus In a large market, or in a market where quantities need not be integers, the demand curve is typically drawn as smooth Consumer surplus is still the area above the price and below the demand curve Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 13 / 32 Consumer Surplus and the Demand Curve What Happens to CS if Price Falls? Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 14 / 32

Producer Surplus and the Supply Curve The Producer Side Now let’s look at that producer’s side of the problem. The supply curve tells us the quantity supplied at each price level,. . . but it also can be interpreted as indicating the marginal cost of producing one more unit. The marginal cost will be the lowest price at which the producer would be willing to sell the next unit of the good or service. Don’t forget that when we talk about costs, we are referring to the opportunity cost . Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 15 / 32 Producer Surplus and the Supply Curve Consider a Single Producer of Shoes - Sam Quantity Sam’s MC 1 $20 2 $40 3 $80 4 $100 Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 16 / 32

Producer Surplus and the Supply Curve Sam’s Marginal Cost Curve The MC generates Sam’s supply curve. Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 17 / 32 Producer Surplus and the Supply Curve Producer Surplus for the Individual So, what is the net gain to Sam if he sells 2 pairs of shoes at $70 per pair? Well, the first pair of shoes cost him $20 to produce, but he sold them for $70, for a net gain (or surplus) of $70 - $20 = $50. For the second pair, his surplus is smaller, since they cost him $40 to produce. In this case, the surplus is $70 - $40 = $30. Sam’s total producer surplus is $40 + $30 = $70 Graphically, this total surplus is the area above the producer’s supply curve and below the price. Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 18 / 32

Producer Surplus and the Supply Curve Sam’s Producer Surplus Graphically Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 19 / 32 Producer Surplus and the Supply Curve More than One Producer Suppose we now have several producers in our shoe market, with MC’s Price Sam Annie Mark Cathy 1 20 40 25 50 2 40 80 50 60 3 80 120 75 70 4 100 160 100 80 Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 20 / 32

Producer Surplus and the Supply Curve Individual MC Graphs Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 21 / 32 Producer Surplus and the Supply Curve The Market Supply for Shoes The market will naturally organize itself from lowest to highest MC Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 22 / 32

Producer Surplus and the Supply Curve What would be the Producer Surplus with P=70? Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 23 / 32 Producer Surplus and the Supply Curve Producer Surplus In a large market, or in a market where quantities need not be integers, the supply curve is typically drawn as smooth Producer surplus is still the area above the supply curve and below the price Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 24 / 32

Producer Surplus and the Supply Curve What Happens to PS if Price Rises? Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 25 / 32 Total Surplus and the Gains from Trade Total Surplus and the Gains from Trade If we put both of these pieces together (i.e., supply and demand), we can see (and measure) the gains from trade. We saw in the last chapter that market forces will cause price to change until the quantity supplied just equals the quantity demanded. This equilibrium results in gains for both sides of the market - Consumers gain in the form of consumer surplus, with those buying paying less (or at least no more) than their MWTP for the goods they buy. - Producers gain in the form of producer surplus, with those selling receiving more (or at least no less) than their MC of production. More impressive is the fact that this allocation is efficient. . . ; i.e., there is no way to move from this equilibrium that will make some people better off, without making other people worse off. Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 26 / 32

Total Surplus and the Gains from Trade Graphically Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 27 / 32 Total Surplus and the Gains from Trade What Happens if... ...we artificially hold back production Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 28 / 32

Total Surplus and the Gains from Trade Efficiency and the Market Any reallocation of buyers or sellers will reduce the overall surplus. Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 29 / 32 Total Surplus and the Gains from Trade The Efficient Market The Efficient Market Performs Four Key Functions It allocates consumption of the good to the potential buyers who value 1 it the most, It allocates sales to the potential sellers who most value the right to 2 sell the good (i.e., those who have the lowest cost) It insures that every buyer values the good more than every seller who 3 sells the good (i.e., there is a surplus from the trade) It insures that every consumer who doesn’t buy the good values it less 4 than every seller who does not sell the good (i.e., there are no additional gains from trade). There are several important caveats Efficient markets are not necessarily equitable; 1 Markets can fail 2 While markets maximize total surplus, they do not maximize the 3 surplus of individuals in the market; Herriges (ISU) Ch. 4: Consumer and Producer Surplus Fall 2010 30 / 32