LECTURE 6 MICROECONOMICS CHAPTER 7 Consumer Producer Surplus

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

Consumer Surplus Welfare Economics 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.

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

The Demand Curve Price of Albums John’s willingness to pay $100 Paul’s willingness to pay 80 70 George’s willingness to pay Ringo’s willingness to pay 50 Demand 0 1 2 3 Quantity of Albums 4 The graph shows the corresponding demand curve. Note that the height of the demand curve reflects buyers’ willingness to pay 4

Measuring Consumer Surplus (a) Price = $80 Price of Albums John’s consumer surplus ($20) $100 (b) Price = $70 Price of Albums John’s consumer surplus ($30) $100 80 70 50 50 Paul’s consumer surplus ($10) Total consumer surplus ($40) Demand 0 1 2 3 4 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

Price and Consumer Surplus Price (a) Consumer surplus at price P 1 Price A A P 1 Consumer surplus C P 1 B Demand 0 (b) Consumer surplus at price P 2 Q 1 Quantity P 2 0 Initial consumer surplus Additional consumer surplus to initial consumers C Consumer surplus to new consumers B F D Demand E Q 1 Q 2 Quantity In panel (a), the price is P 1, the quantity demanded is Q 1, and consumer surplus equals the area of the triangle ABC. When the price falls from P 1 to P 2, as in panel (b), the quantity demanded rises from Q 1 to Q 2, 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 6 BCED) and in part because new consumers enter the market at the lower price (area CEF).

Producer Surplus Willingness to Sell 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

The Supply Curve Price of House Painting Supply $900 800 Mary’s cost Frida’s cost 600 500 Georgia’s cost Grandma’s cost 0 1 2 3 4 Quantity of Houses Painted The graph shows the corresponding supply curve. Note that the height of the supply curve reflects sellers’ costs. 8

Measuring Producer Surplus Price of House Painting (a) Price = $600 Supply Price of House Painting $900 800 600 500 Grandma’s producer surplus ($100) (b) Price = $800 Supply Total producer surplus ($500) Georgia’s producer surplus ($200) Grandma’s producer surplus ($300) 0 1 2 3 4 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

Price and Producer Surplus Price (a) Producer surplus at price P 1 Price P 2 P 1 Producer surplus P 1 C A 0 Supply Additional producer surplus to initial producers Supply B (b) Producer surplus at price P 2 D E B Initial consumer surplus C F Producer surplus to new producers A Q 1 Quantity 0 Q 1 Q 2 Quantity In panel (a), the price is P 1, the quantity supplied is Q 1, and producer surplus equals the area of the triangle ABC. When the price rises from P 1 to P 2, as in panel (b), the quantity supplied rises from Q 1 to Q 2, 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 10 in part because new producers enter the market at the higher price (area CEF).

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

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

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.

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

Homework Questions for Review: 1, 2, 4, 5 (4 Th Ed – same) Problems and Applications: 3, 4, 5 (part a, b) 4 Th ED: 2, 3, 4 (part a, b)