8 Mutual Gains from Trade We rely on other people to produce things we want: We are not forced to rely on others. Why do we voluntarily rely on others through the market process? We must answer this question: What are the gains from mutually beneficial exchange?

Mutual gains—Simple Example You buy food from a grocer because she is willing to sell to you at a price that is: 1) less than the value you place on the good, and/or 2) less than your costs of producing it yourself Therefore, you gain from shopping at grocer (consumer surplus) Grocer sells to you. You are willing to pay a price that is: 1) more than the cost of producing the good, and/or 2) more than the seller’s next best alternative Therefore, grocer gains from selling to you (producer surplus) We are joined together by mutual gains through market exchange

The consumers’ perspective Look at demand side of market and ask: What is the total value in use to consumers of the quality Q*? It is the total area under demand curve from 0 to Q* (OABQ*) People usually do not have to give up all of this because suppliers will deliver at a price of P* Price A B P* Demand O Q* Quantity

Consumer surplus The gains from trade going to consumers: Total use value (ABQ*0) minus Total expenditures (P*BQ*0) equals Consumer surplus (ABP*) Price A B P* Demand Q* Quantity

The producers’ perspective Look at supply side of market and ask: What is the total cost to producers of the quantity Q*?” Three equal descriptions are: 1. minimum you would accept to produce Q* rather than Q=0 2. sum of the marginal costs from 0 to Q* 3. area under the supply curve Producers usually do not have to settle for MC, because demanders will pay a price of P* Price Supply = MC P* B Q* Quantity

Producer surplus The gains from trade going to the producer: Total revenue (P*BQ*0) Minus Total costs (0CBQ*) [Costs must be recovered or no production.] Equals Producer surplus (P*BC) Price S = MC P* B C Q* Quantity

Putting It All Together Price Demand Market Price Price Supply A A S S B B P* P* P* B D D C C Q* Quantity Q* Quantity Q* Quantity There are gains to suppliers and demanders — room for bargaining. Who gets producer and consumer surplus? Area ABC is up for grabs!