1. 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

2. 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*

3. 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).

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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)

13. 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 = = 200

14. 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

15. The Effect of a Sales Tax

16. Deadweight Loss

17. 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

18. 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

19. Market Equilibrium: The Invisible Hand

20. 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.

21. 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

22. 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

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