Consumer’s and Producer’s Surplus Frank and Bernanke – Chapter 3 Lecture 6 Consumer’s and Producer’s Surplus Required Text Frank and Bernanke – Chapter 3

Market Equilibrium Earlier, we saw that market equilibrium occurs when the quantity of a good offered by sellers at a given price equals the quantity buyers are willing and able to purchase at that same price. That is, market equilibrium occurs at price equals P* and quantity equals Q*. P S P* D Q Q*

Measuring the Gains from Trade Whenever an exchange (or trade) takes place between a consumer and a producer, both parties gain from that exchange (or trade) The consumer’s gain from the trade is termed as The consumer’s surplus The producer’s gain from the trade is termed as The producer’s surplus The sum of the consumer’s and producer’s surplus is the total gains from a particular trade (or exchange).

The Consumer’s Surplus The Consumer’s Surplus is defined as the difference between what the consumer would be willing to pay and what the consumer actually pays to acquire a given quantity of a good. In other words, the consumer’s surplus is the amount by which the value of her purchases exceeds what she actually pays for them

A Numerical Example Price Quantity Willing to Pay Actual Payment Consumer Surplus 15 1 13 2 28 26 10 3 38 30 8 7 4 45 17 5 50 25 6 52 12 40 53 46

The Consumer’s Surplus Note that for buying Q1 units, consumer is willing to pay P1/unit of product. For buying Q2 units, consumer is willing to pay P2/unit of product. But at market equilibrium, the consumer buys Q3 units of the product for P3/unit of product. Thus, at the equilibrium price of P3/unit of product, consumer actually ends up paying less than what he is willing to pay. This difference is called the Consumer’s Surplus. P S P1 P2 P3 D Q Q1 Q2 Q3

The Consumer’s Surplus In general, the Consumer’s Surplus can then be calculated as the area under the demand curve and above the price level, i.e., the shaded area. P S P D Q Q

The Producer’s Surplus The Producer’s Surplus is defined as the dollar amount by which a firm benefits by producing its profit maximizing level of output. In other words, a Producer’s Surplus is the amount by which the producer’s revenue exceeds her variable production costs

Producers’ Surplus Note that for selling Q1 units, producer is willing to accept P1/unit of product. For selling Q2 units, producer is willing to accept P2/unit of product. But at market equilibrium, the consumer sells Q3 units of the product at P3/unit of product. Thus, at the equilibrium price of P3/unit of product, producer actually ends up receiving more than what he is willing to accept. This difference is called the Producers’ Surplus. P S P3 P2 P1 D Q Q1 Q2 Q3

The Producer’s Surplus In general, Producers’ Surplus can then be calculated as the area above the supply curve and below the price level, i.e., the shaded area. P S P1 D Q Q1

The Consumer’s and Producer’s Surpluses The Consumer’s Surplus is given by the area under the demand curve and above the price level. The Producer’s Surplus is given by the area above the supply curve and below the price level. So the Total Surplus is the sum of the Producer’s Surplus and the Consumer’s Surplus P S P1 D Q Q1

Consumer’s and Producer’s Surpluses A Mathematical Application Suppose that the demand and supply function are given by QD = 40 – 2P QS = 2P Market equilibrium occurs at the intersection of the demand and supply functions. Thus, at the market equilibrium QS = QD Now, setting QS = QD , we have 40 – 2P = 2P => 4P = 40 => P* = 10 (equilibrium price) Plugging the equilibrium price to either the demand or supply function QD = 40 – 2(10) => QD = 20 QD = 20 = QS (equilibrium quantity)

Consumer’s and Producer’s Surpluses A Mathematical Application The consumer’s surplus is the area of the triangle between the price line and demand curve For QD = 20, P = 10 (the equilibrium price and quantity exchanged) For QD = 0, P = 20 (this is the vertical intercept of the inverse demand function) The vertical intercept above the price line is (20-10=) 10 The area of the triangle between the price line and the demand curve, i.e., CS= (1/2)*20*10 = 100 The producer’s surplus is the area of the triangle between the price line and supply curve For QS = 20, P = 10 (the equilibrium price and quantity exchanged) The vertical intercept above the price line is 10 The area of the triangle between the price line and the supply curve, i.e., PS= (1/2)*20*10 = 100 The total surplus, TS = CS + PS = 100+100 = 200

Total Economic Surplus or Social Surplus Total Economic Surplus or Social Surplus: The sum of the surpluses from trade of a commodity or service to all participants (all consumers and producers) Total economic surplus from all exchanges of a commodity occurred at a particular point in time can be calculated in the same way, using the aggregate (market) demand and supply functions (curves) Consumers’ surplus is the area of the triangle between the equilibrium price line and the market demand curve Producers’ surplus is the area of the triangle between the equilibrium price line and the market supply curve Total Economic Surplus = Consumers’ Surplus + Producers’ Surplus

The Effect of a Sales Tax

Deadweight Loss

Excise Tax Impacts on Consumers’ and Producers’ Surplus An excise tax per unit of the commodity shifts the supply curve from S to S1. Resulting in a change in the equilibrium price from P1 to P2 and equilibrium quantity from Q1 to Q2. Before tax CS = abP1 After tax CS = adP2 Tax decreased CS Before tax PS = cbP1 After tax PS = edP2 Tax decreased PS Before tax Total Surplus = abc After tax Total Surplus = ade Tax decreased Total Surplus Society overall is worse off due to the excise tax P S a d P2 P1 b e D c Q Q2 Q1

Increase in Income Impacts on Consumers’ and Producers’ Surplus Increase in income shifts the demand curve from D to D1. Resulting in a change in the equilibrium price from P1 to P2 and equilibrium quantity from Q1 to Q2. Initial CS = abP1 Later CS = edP2 Not sure if CS increased or decreased. Initial PS = cbP1 Later PS = cdP2 Increase in PS Initial Total Surplus = abc Later Total Surplus = edc An increase in Total Surplus Society overall is better off due to an increase in consumer income. P e S a d P2 b P1 D1 D c Q Q1 Q2

Market Equilibrium: The Invisible Hand

Equilibrium Principle Markets communicate information effectively Value buyers place on the product Opportunity cost of producing the product When the market for a good is in equilibrium, the seller’s cost of producing an addition unit of the good is the same as the consumer’s benefit of having that additional unit MC = MB When a market is not in equilibrium, it is possible to identify mutually beneficial exchanges. Equilibrium Principle: A market in equilibrium leaves no unexploited opportunities for individuals but may not exploit all gain achievable through collective action.

Economic Efficiency Socially Optimal Quantity: The quantity of a good that results in the maximum possible economic surplus from producing and consuming the good. Economic Efficiency: An economy is said to be efficient when all goods and services are produced and consumed at their respective socially optimal level Is the market equilibrium quantity of a good efficient? Only when the seller pays the full cost of production and the buyer captures the full benefit of the good MC = MB the equilibrium quantity maximizes social surplus − socially optimal

Smart for One, Dumb for All Producers sometimes shift costs to others Pollution is like getting free waste disposal services Total marginal cost = seller's marginal cost plus marginal cost of pollution When costs are shifted, supply is greater than socially optimal Buyers may create benefits for others Marginal benefit is less than the full social benefit Vaccinations, my neighbor's landscaping The demand for these goods is less than socially optimal Regulation, taxes and fines, or subsidies can move the market to optimal level

Efficiency Principle Efficiency Principle: When the economic pie (social surplus) grows larger through efficiency, everyone can have a larger slice.