Consumer Surplus, Producer Surplus, and Market Efficiency
Consumer Surplus, Producer Surplus, and Market Efficiency
Outline
Consumer Surplus
Producer Surplus
Total Surplus
Market Efficiency
Welfare Economics
Definition: The study of how the allocation of resources affects economic well-being.
Focus on benefits that buyers and sellers receive from engaging in market transactions.
Objective: To maximize these economic benefits for society.
Key Point: In any market, the equilibrium of supply and demand maximizes the total benefits received by all buyers and sellers combined.
Consumer Surplus: Definition
Consumer Surplus: The amount a buyer is willing to pay for a good minus the amount the buyer actually pays.
Willingness to Pay: The maximum amount that a buyer will pay for a good; reflects how much the buyer values the good.
Formula: CS = WTP - P
Where CS is consumer surplus, WTP is willingness to pay, and P is the price paid.
Consumer Surplus: Example
Consumer surplus measures the benefit buyers receive from participating in a market.
It is closely related to the demand curve, which reflects buyers' willingness to pay at different price levels.
Consumer Surplus: Demand from Last Example
At any quantity, the price given by the demand curve shows the willingness to pay of the marginal buyer.
Marginal Buyer: The buyer who would leave the market first if the price were to increase even slightly.
Consumer Surplus: Calculation
If P = P_1, consumer surplus is represented by the area below the demand curve and above the price line.
Example Calculation:
Consider P1 = 10, Q1 = 100, and Point A as the demand choke price of 20:
CS = rac{1}{2} imes base imes height = rac{1}{2} imes 100 imes (20 - 10)
Which simplifies to CS = 500.
Visual Representation of Consumer Surplus
In panel (a):
Price = P1, Quantity Demanded = Q1, Consumer Surplus = Area of triangle ABC.
When the price falls from P1 to P2 (panel (b)):
Quantity demanded rises from Q1 to Q2 and consumer surplus rises to the area of triangle ADF.
The increase in consumer surplus occurs because:
Existing consumers pay less (Area BCED).
New consumers enter the market at the lower price (Area CEF).
Producer Surplus: Definition
Producer Surplus: The amount a seller is paid for a good minus the seller’s cost of providing it.
Cost: The value of everything a seller must give up to produce a good.
Formula: PS = P_{received} - WTS
Where PS is producer surplus and WTS is willingness to sell.
Producer Surplus: Example Question
Given the following market prices, calculate PS:
If market price = 900, PS = ____
If market price = 800, PS = ____
If market price = 500:
Sellers:
Vincent: Cost $900
Claude: Cost $800
Pablo: Cost $600
Andy: Cost $500
Producer Surplus: Relationship to Supply
Producer surplus is closely related to the supply curve, which reflects the costs of the suppliers.
The supply schedule shows the minimum price at which suppliers are willing to sell:
At any quantity, the price on the supply curve shows the cost to the marginal seller.
Marginal Seller: The seller who would leave the market first if the price were to decrease.
Producer Surplus: Visual Representation
In panel (a):
Price = P1, Quantity Supplied = Q1, Producer Surplus = Area of triangle ABC.
When the price rises from P1 to P2 (panel (b)):
Quantity supplied rises from Q1 to Q2, and producer surplus rises to the area of triangle ADF.
The increase in producer surplus occurs because:
Existing producers receive more (Area BCED).
New producers enter the market at the higher price (Area CEF).
Example: Calculate Equilibrium Price and Quantity
Given equations:
Demand: P = 100 - 0.5Q
Supply: P = 20 + 0.5Q
Calculate equilibrium price and quantity.
Find CS and PS at equilibrium.
Example: Equilibrium Prices and Price Controls
With an equilibrium price of 60 and equilibrium quantity of 80, consider:
If a price ceiling of 40 is set, calculate CS and PS.
If a price floor of 70 is set, calculate CS and PS.
Example Calculation at Equilibrium
For: 100 - 0.5Q = 20 + 0.5Q
Solving gives Q = 80, and P = 60.
Compute CS and PS at equilibrium:
CS = rac{1}{2}(80)(100 - 60) = 1600
PS = rac{1}{2}(80)(60 - 20) = 1600
Observation: CS and PS are equal due to the specific market demand and supply functions; they may differ under alternative equations.
Total Surplus
Total Surplus (TS) is defined as the sum of consumer surplus and producer surplus.
Formula: TS = CS + PS
Breakdown:
Consumer Surplus = Value to buyers – Amount paid by buyers.
Producer Surplus = Amount received by sellers – Cost to sellers.
Therefore: TS = (Value to buyers) - (Cost to sellers).
Market Efficiency
Efficiency Definition: A property of resource allocation that maximizes the total surplus received by all members of society.
Equality Definition: A property that distributes economic prosperity uniformly among society members.
Consumer and Producer Surplus in Market Equilibrium
Total surplus (the sum of consumer and producer surplus) represents the area between the supply and demand curves up to the equilibrium quantity.
Market Efficiency and Market Failure
Forces of supply and demand typically allocate resources efficiently under certain conditions:
Assumptions:
Markets are perfectly competitive.
Market outcomes affect only buyers and sellers in that market.
Market Inefficiency
When the above assumptions do not hold, the statement "Market equilibrium is efficient" may no longer be valid.
In reality, competition often deviates from perfection.
Key concepts related to market power:
When a single buyer or seller (or a small group) controls market prices, it leads to inefficiencies.
Market Inefficiency Continued
Decisions made by buyers and sellers can affect people who are not actively participating in the market.
Externalities: Events that cause welfare in a market to depend on more than the value to buyers and the cost to sellers.
Inefficient Equilibrium: Can arise from various externalities, leading to outcomes that are not optimal from the perspective of society as a whole.