Consumer Surplus and Producer Surplus Welfare Economics Consumer Surplus and Producer Surplus

Reading Material See the “Consumer and Producer Surplus” subsection of the “Costs and Benefits of a Tariff” section of Chapter 9 (“The Instruments of Trade Policy”) of International Economics: Theory and Policy, 10th edition, by Paul Krugman, Maurice Obstfeld, and Marc Melitz

Revisiting The Market Equilibrium The theory of supply and demand shows how markets allocate scarce resources among competing needs. But are the equilibrium price and the equilibrium quantity the right price and the right quantity from society’s point of view? This question takes us into welfare economics.

Welfare Economics Welfare economics is the study of how the allocation of resources affects economic well-being It shows that: Both buyers and sellers receive benefits from taking part in the market The equilibrium outcome in the theory of supply and demand maximizes the total welfare of buyers and sellers

Two main concepts When buyers and sellers trade willingly, it must be because they expect to benefit Consumer surplus measures economic welfare of the buyers. Producer surplus measures economic welfare of the sellers.

Consumer surplus

Willingness to pay To define consumer surplus we first need to define “willingness to pay.” Willingness to pay is the maximum amount that a buyer will pay for a good. It measures how much the buyer values the good.

Willingness to pay: background Assume there is a commodity such that every additional unit of it increases a consumer’s happiness by the same amount In other words, the consumption of additional units of this commodity induces neither boredom nor addiction Possible examples: potato chips? candy? Then the consumer’s willingness to pay for a product is a good measure of the happiness that he or she gets from it

Willingness to pay: background Suppose a bag of potato chips provides a fixed amount of happiness If your willingness to pay is 4 bags of potato chips for a shirt, and 2 bags of potato chips for a cup of coffee, then one can safely say that the shirt makes you twice as happy as the cup of coffee So, your willingness to pay for a commodity is a good measure of how much you like it

Willingness to pay: background If the dollar price of a bag of potato chips is known, willingness to pay in the example above can also be expressed in dollars

Willingness to pay: background Another example: if you are willing to pay $15 for a shirt, and if a bag of potato chips always gives you 3 “haps” of happiness, and sells at the price of $0.50 each, then the shirt gives you 90 “haps” of happiness.

Willingness to pay: background In other words, your willingness to pay for the shirt is a monetary measure of the happiness you get from the shirt, and it is proportional to the happiness you get from the shirt, as measured in “haps”

Table 1 Four Possible Buyers’ Willingness to Pay For a mint-condition recording of Elvis Presley’s first album I will illustrate consumer surplus through this extended example.

Consumer Surplus Consumer surplus is the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it. Example: If the Elvis album’s price is $75… Buyer Willingness to Pay Consumer Surplus Buy? John 100 25 Yes Paul 80 5 George 70 -5 No Ringo 50 -25

Market Demand The market demand shows the quantities demanded by buyers at different prices. We can use the willingness-to-pay numbers to calculate the market demand See the next slide

The Demand Schedule Buyer Willingness to Pay John 100 Paul 80 George 70 Ringo 50 The Demand Schedule

Figure 1 The Demand Curve Buyer Willingness to Pay John 100 Paul 80 George 70 Ringo 50 Figure 1 The Demand Curve Price of Demand Album $100 John ’ s willingness to pay 80 Paul ’ s willingness to pay 70 George ’ s willingness to pay 50 Ringo ’ s willingness to pay The height of the demand curve at any quantity shows the willingness to pay of whoever bought the last unit. 1 2 3 4 Quantity of Albums Copyright©2003 Southwestern/Thomson Learning

Area of a Rectangle Area = Width × Height Height Width

Figure 2 Measuring Consumer Surplus with the Demand Curve Buyer Willingness to Pay Consumer Surplus Buy? John 100 30 Yes Paul 80 10 George 70 No Ringo 50 -20 (b) Price = $70.01 Price of Demand Album $100 1. The area under the demand curve measures the total willingness to pay for the quantity demanded. 80 70 50 2. It is also the maximum willingness to pay that could be generated from that quantity. John’s willingness to pay Paul’s willingness to pay 1 2 3 4 Quantity of Albums

Interpersonal comparability We just saw that the total area under the demand curve is $180, and that is also the total willingness to pay of John and Paul But can we say it is the total happiness of John and Paul?

Interpersonal comparability Yes, if there is a commodity—say, a bag of potato chips—that provides an unchanging amount of happiness to the consumer, and if John’s happiness and Paul’s happiness are comparable, and if both John and Paul get the same happiness from a bag of potato chips That’s a lot of if’s! But we will make these simplifying assumption anyway Not just for John and Paul, but for everybody

Utilitarianism The idea that the happiness of an individual can be measured numerically, the happiness of a group of people can be measured numerically, the happiness of a group of people is simply the sum of the numbers representing the happiness of the individual members of the group, and that social policy should seek to maximize the total happiness of society, is called utilitarianism Welfare analysis in this course takes utilitarianism as its guiding philosophy

The market and the planner Suppose the government has two copies of the Elvis album. The government’s goal is to give them to two of the four guys so as to generate the maximum happiness. Who will get the government’s copies? Obviously, John and Paul, same as in the market outcome we saw before. So, the market does the best that the government could have done Price = $70 Buyer Willingness to Pay John 100 Paul 80 George 70 Ringo 50

Willingness to Pay from the Demand Curve Price A Demand The area under the demand curve measures the total willingness to pay of the consumers who bought Q1 units. It also measures the maximum willingness to pay that could be obtained from Q1 units P1 Q1 B C Quantity

Using the demand curve to measure willingness to pay In general, the area under the demand curve up to the quantity demanded is a graphical measure of the total willingness to pay of the buyers. It is also the maximum willingness to pay that can be obtained from that quantity That is, the government could not give away that quantity in a way that generates higher willingness to pay.

Figure 3 How the Price Affects Consumer Surplus (a) Consumer Surplus at Price P Price A Consumer surplus Demand Consumer Surplus (ABC) + Total Payment (OBCQ1) = Willingness to Pay (OACQ1) P1 Q1 B C Total Payment Quantity

Using the Demand Curve to Measure Consumer Surplus In general, the area below the demand curve and above the price measures the consumer surplus.

Figure 3 How the Price Affects Consumer Surplus (b) Consumer Surplus at Price P Price A B C Initial consumer surplus Demand Consumer surplus to new consumers P1 Q1 D E F P2 Q2 Additional consumer surplus to initial consumers Quantity

Shifts in Demand We know that the demand curve can shift, for reasons such as a change in tastes, and a change in the prices of related goods Given that the demand for a product can shift as a result of a change in the price of a related good, does it make sense to say that the area under the demand curve measures the happiness consumers get from the product? Note to myself: The welfare analysis of this chapter works best for a product X such that each consumer maximizes the quasi-linear utility function U(X,Y) ≡ V(X) + aY. In this case, the demand curve for X is the equation px = V’(X)py/a. So, the demand curve for X rises if V’(X) increases or if py/a, which is the reciprocal of marginal utility of money, increases. Income has no effect! The area under the demand curve up to X = X0, is V(X0) py/a. This is the willingness to pay. It is also the objective or psychological happiness – in “haps” – when divide by the scaling factor, which is the reciprocal of marginal utility of money. A unit of good Y always provides the same happiness, a; so good Y is like the bag of potato chips in my lecture.

Shifts in Demand Continued from the previous slide Yes! Keep in mind that the area under the demand curve is a monetary measure of the happiness obtained by buyers The objective or psychological happiness obtained from a shirt may be unchanged even if the monetary willingness to pay for the shirt changes, perhaps because of a change in the price of a related good In an earlier slide, a bag of potato chips was assumed to always provide 3 “haps” of happiness, and sold at a price of $0.50. Consequently, consumers were wiling to pay $15 for a shirt that provided 90 “haps” of happiness. It follows that if the price of a bag of potato chips rises to $1, consumers would then be willing to pay $30 for the same shirt, leading to an upward shift in the demand curve for shirts.

Producer surplus

Producer Surplus Producer surplus is the amount a seller is paid for a good minus the seller’s cost. It measures the net benefit to sellers It is almost but not quite the same as profit.

Cost of production The cost of production is the market value of all resources used in production By all, I do mean all. Even if some resources used in production were obtained for free, their market value must be included in cost.

Table 2 The Cost of Painting a House for Four Possible Sellers

Costs → Supply The supply of house painting services shows the quantity of house painting services supplied at all possible prices The cost numbers in the previous slide can be used to calculate supply of house painting services

Costs → Supply Seller Cost ($) Mary 900 Frida 800 Georgia 600 Grandma 500

Figure 4 The Supply Schedule and the Supply Curve Seller Cost ($) Mary 900 Frida 800 Georgia 600 Grandma 500 The height of the supply curve at any quantity shows the production cost to whoever produces the last unit.

Producer Surplus Producer surplus is the amount a seller is paid minus the seller’s cost Example: If the going price for getting a house painted is $700 we get the following table. Seller Cost ($) Producer Surplus Sell? Mary 900 -200 No Frida 800 -100 Georgia 600 100 Yes Grandma 500 200

Using the Supply Curve to Measure Producer Surplus The area below the price and above the supply curve measures the producer surplus.

Figure 5 Measuring Producer Surplus with the Supply Curve (b) Price = $799.99 1. The area under the supply curve is the cost of the quantity supplied Price of House Supply Painting 2. It is also the lowest cost for that quantity $900 800 Seller Cost ($) Producer Surplus Sell? Mary 900 -100 No Frida 800 Georgia 600 200 Yes Grandma 500 300 600 500 Grandma’s cost Georgia’s cost 1 2 3 4 Quantity of Houses Painted

Is there a better alternative to the market system? If the government had to get two houses painted, who would get the job? Grandma and Georgia, of course. And, as we just saw, that’s exactly what happens in the market outcome. So, the market achieves the best that the government could have achieved Seller Cost ($) Mary 900 Frida 800 Georgia 600 Grandma 500

Figure 5 Measuring Producer Surplus with the Supply Curve (b) Price = $800 1. The rectangular area under the price and up to the quantity supplied is the Total Revenue. Price of House Supply Painting Total producer surplus ($500) 2. The area under the price and above the supply is the Producer Surplus. $900 800 Seller Cost ($) Producer Surplus Sell? Mary 900 -100 No Frida 800 Georgia 600 200 Yes Grandma 500 300 600 Georgia ’ s producer surplus ($200) 500 Grandma ’ s producer surplus ($300) 1 2 3 4 Quantity of Houses Painted

Figure 6 How the Price Affects Producer Surplus (a) Producer Surplus at Price P Price Supply B A C Q1 P1 Producer surplus Total Revenue (OBCQ1) = Production Cost (OACQ1) + Producer Surplus (ABC) Production Cost Quantity

Figure 6 How the Price Affects Producer Surplus (b) Producer Surplus at Price P Price Additional producer surplus to initial producers Supply D E F P2 Q2 Producer surplus to new producers B P1 C Initial producer surplus A Q1 Quantity

Figure 7 Consumer and Producer Surplus in the Market Equilibrium Price A C B D E Consumer surplus Demand Supply Equilibrium price quantity Producer surplus Quantity