Chapter 7: Consumer & Producer Surplus Welfare Economics Chapter 7: Consumer & Producer Surplus

Welfare Economics Welfare Economics = the study of whether a market allocation is socially optimal (desirable) Market equilibrium maximizes total welfare for society if MC = MB Unless there is a market failure such as externalities, price fixing, collusion etc… Supply = Marginal Cost (MC) Demand = Marginal Benefit (MB)

EFFICIENCY vs. EQUITY Efficiency = an allocation which maximizes the Total Surplus (welfare) Total Surplus = Consumer Surplus + Producer Surplus Equity = the fairness of the distribution of well-being among the various buyers and sellers Equity is not addressed in free markets Welfare Economics attempts to maximize efficiency not equity.

CONSUMER SURPLUS Consumer Surplus (CS) = measures the welfare (surplus) of the buyer CS = maximum price willing to pay (MB) − price paid Demand Curve = Marginal Benefit Curve CS = MB – Price Paid Example: If a consumer is willing to pay $15 Then: CS = $15 - $10 = $5 consumer surplus $10 $15 -----------

Demand Schedule & the Demand Curve Demand curves depicts the quantity buyers are willing to pay (MB) at each price Consumers value goods differently So demand curve states the marginal benefit of each consumer

Individual Consumer Surplus @ Equilibrium Price = $70 Price of Demand CS = MB – Price Paid Album $100 John ’ s CS = $30 ($100 - $70) 80 Paul ’ s CS = $10 ($80 - $70) P1 70 Total consumer surplus ($40) 50 1 2 3 4 Quantity of Albums

Calculating Total Consumer Surplus Price A The triangle above current market price is the“welfare” of all consumers $200 D1 = MB1 Consumer Surplus Total Consumer Surplus @ $100 price = $10 ½ * 1 * 20 = $10 [½ base * height] $100 20 B C Quantity

Consumer Surplus Handout Please complete Consumer Surplus worksheet

Producer Surplus Producer Surplus (PS) = measures the welfare of the seller PS = price received − minimum price firms will sell good/service (MC) Supply = Marginal Cost Curve PS = Price Received - MC

Rising Prices & Producer Surplus Additional producer surplus to initial producers Supply = MC As Price Producer Surplus D E F P2 Q2 Producer surplus to new producers B P1 C Initial producer surplus A Q1 Quantity

Total Surplus (Welfare) = Sum of CS + PS Price E1 CS = MB – Price Paid Consumer Surplus D = MB S = MC Total Surplus = CS + PS P1 Q1 Producer Surplus PS = Price Received - MC Quantity

Producer Surplus & Total Welfare Welfare & Surplus are interchangeable terms ( i.e. Total Welfare is same as Total Surplus)

Producer Surplus Test

Sample Problem ----------------- -------------------- 1) Calculate the initial consumer surplus at equilibrium price of $300 Price 2) Calculate the change in consumer surplus when price falls to $100 A 500 3) After the price decreases from $300 to $100 a) what gain is for old consumers (people who also bought when price = $300) b) what gain in consumer surplus is for new consumers E1 300 ----------------- -------------------- E2 100 ---------------------------------- ----- D1 50 100 Quantity