1. LECTURE #6: MICROECONOMICS CHAPTER 7
Consumer & Producer Surplus
Market Efficiency
Market Failure

2. Consumer Surplus Welfare Economics Willingness to Pay
How the allocation of resources affects economic well-being
Willingness to Pay
How 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.

3. 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

4. The Demand Curve $100 80 70 50 Price of Albums Demand 4 3 1 2
John’s willingness to pay
Paul’s willingness to pay
George’s willingness to pay
Ringo’s willingness to pay 4 3 1 2
Quantity of Albums
The graph shows the corresponding demand curve. Note that the height of the demand curve reflects buyers’ willingness to pay 4

5. Measuring Consumer Surplus
(a) Price = $80
(b) Price = $70
$100 80 70 50
Price of
Albums
$100 80 70 50
Price of
Albums
Demand
Demand
John’s consumer
surplus ($30)
John’s consumer
surplus ($20)
Paul’s consumer
surplus ($10)
Total consumer
surplus ($40) 4 3 1 2
Quantity of Albums 4 3 1 2
Quantity of Albums
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. 5

6. Price and Consumer Surplus
(a) Consumer surplus at price P1
(b) Consumer surplus at price P2
Price
Price A A
Demand
Demand
Additional consumer surplus to initial consumers
Initial
consumer
surplus
Consumer
surplus C C P1 P1
Consumer surplus
to new consumers B B Q1 Q1 F P2 D E Q2
Quantity
Quantity
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). 6

7. Producer Surplus Willingness to Sell Measuring Producer Surplus
Covering your costs is Job #1.
Producer Surplus = Amount Received – Costs
Measuring Producer Surplus
Higher prices – increase producer surplus
Surplus = Sell Price minus Cost to Produce

8. The Supply Curve $900 800 600 500 Price of House Painting Supply 4 3 1
Mary’s cost
Frida’s cost
Georgia’s cost
Grandma’s cost 4 3 1 2
Quantity of Houses Painted
The graph shows the corresponding supply curve. Note that the height of the supply curve reflects sellers’ costs. 8

9. Measuring Producer Surplus
(a) Price = $600
(b) Price = $800
$900
800
600
500
Price of
House
Painting
$900
800
600
500
Price of
House
Painting
Supply
Supply
Total producer
surplus ($500)
Georgia’s producer
surplus ($200)
Grandma’s producer
surplus ($300)
Grandma’s producer
surplus ($100) 4 3 1 2
Quantity of Houses Painted 4 3 1 2
Quantity of Houses Painted
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. 9

10. Price and Producer Surplus
(a) Producer surplus at price P1
(b) Producer surplus at price P2
Price
Price
Supply
Supply
Additional producer surplus to initial producers E F D P2 Q2
Producer surplus
to new producers B B P1 P1 C C Q1
Initial
consumer
surplus Q1
Producer
surplus A A
Quantity
Quantity
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). 10

11. Market Efficiency Three Definitions
Consumer 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

12. Market Efficiency Allocation of Resources in Fee Markets
Allocate 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 Value
Supply Curve represents value to producers.
Demand curve represents value to consumers

13. Market Efficiency Importance of Equilibrium to Value
At quantities below equilibrium, consumer value is greater than producer cost.
At quantities above equilibrium, cost to sellers is greater than value to buyers.

14. 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 Externalities
Side 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

15. 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)