1 Surplus Measures

2 An Alternative View of the Demand Curve u An alternative interpretation of the demand curve is that it represents the consumer’s marginal willingness to pay or $marginal benefit for the quantity specified. u So, another way of looking at the demand curve is that it tells you the $marginal benefit at each unit of consumption. u $Total benefit of consumption would then be the sum of all the marginal benefits up to, say, X units.

3 Willingness to Pay u Think of the total amount you would pay for X units (say it is $27) and then for X-1 units (say it is $25). Your marginal willingness to pay for that Xth unit is $2 (= ). u Alternatively, we could say that your quantity demanded at the price $2/unit is X because you are willing to pay up to $2/unit for the Xth unit.

4 Consumers Surplus u For one individual: consumer’s surplus (CS) is the difference between the consumer’s total willingness to pay ($total benefit) and what the consumer actually did pay ($total expenditure). u CS = the area between the consumer’s demand curve and the market price line. u To go from individual consumer’s surplus to market consumers’ surplus, just use the market demand, which aggregates all the individuals.

5 Example: Li’s Willingness to Pay for Wheat and Consumer Surplus u The table at the right shows Li’s willingness to pay for the indicated quantities of wheat. u Her marginal marginal willingness to pay (marginal benefit) is the difference between her willingness to pay for X and X-1 units of wheat. u Li’s demand curve would be the plot of her marginal willingness to pay against number of units. u Marginal consumer surplus on each unit is the difference between marginal willingness to pay and the price she actually pays, P W =$2/lb in this example. u Total consumer surplus is the sum of all entries in the marginal consumer surplus column.

6 Consumer Surplus and Quantity Demanded u If the price of wheat is $2/lb., then Li buys 10 lbs. of wheat, the point where her marginal benefit of wheat equals its price. u Notice that the marginal willingness to pay column (marginal benefit) is just Li’s demand for wheat. u When P W =$2 and W=10, Li’s consumer surplus is $72.50, indicating that she would have been willing to pay an additional $72.50 for the wheat she consumed (above the $20 she had to pay). u Try it for P W = $4.00

7 Graphical Measure of Li’s Consumer Surplus u The area under the demand curve and above the market price is the total consumer surplus. u The arrow on the right shows Li’s total consumer surplus when the market price of wheat is $2/lb.

8 Market Consumer Surplus Question u The table at the right is a sample market demand curve. u Question: At a market price of $2.00, what is the total consumer surplus?

9 Market Consumer Surplus Answer u At a market price of $2.00, total expenditures are $14 = 7 x $2.00 u Total willingness to pay is $40 = u Total consumer surplus = $40 - $14 = $26. u Total consumer surplus = sum of marginal consumer surplus = 26 =

10 Graph of Market Consumer Surplus u As in the case of individual consumer surplus, the area below the demand curve and above the market price measures the total market consumer surplus.

11 Why Measure Consumer Surplus? u An individual’s total consumer surplus on a purchase measures the gain to the consumer from the market transaction. u In the market as a whole, the total consumer surplus measures the gain to society from the existence of the market equilibrium price.

12 Producers Surplus u Producers surplus measures the gain to firms from selling all units at the market price. u Producers surplus is the supply-side equivalent of consumers surplus. u Think of the supply curve as measuring the marginal costs of production. u For one firm: producer’s surplus (PS) is the difference between what the firm gets in revenue ($total revenue) and what the sum of the marginal costs are ($total variable costs). u PS = the area between the market price line and the firm’s supply curve. u To go from individual producer’s surplus to market producers’ surplus, just use the market supply, which aggregates all the firms.

13 Producers Surplus Demand=MB Supply=MC P Quantity P* X* u Suppose the market equilibrium occurs at P* & X*. u Total revenue to producers is the area OP*BX*. u Sum of marginal costs is the area OABX*. u Producers surplus is the red shaded area AP*B. A B O

14 Demand and Supply Revisited u Market demand reflects marginal benefit. u Market supply reflects marginal costs. u Consumers surplus measures the gains from trade to the consumers. u Producers surplus measures the gains from trade to the producers. u Total gains from trade - or total surplus - or net social surplus - is the sum of consumers and producers surplus. It can also be thought of as $total benefit-sum of $marginal costs.

15 Net Social Surplus Demand=MB Supply=MC $ Quantity P* X* u The market equilibrium occurs at P* & X*. u $TB = area OCBX* u $total expenditure = area OP*BX* u $CS is the top blue shaded area P*CB u $total revenue =area OP*BX* u sum of $mc = OABX* u $PS = bottom red shaded area AP*B u $Net social surplus = area ACB = the top and bottom triangles. B O A C

16 Selling My House u Old address: 133 Tompkins St. u New address: 132 Tompkins St. u Problem: we bought the new house before selling the old one. u Our minimum selling price (after 2 years) = $55,000. u Potential buyer Abe: maximum buying price = $45,000 u So, no deal with Abe.

17 Selling My House u Potential (and last) buyer Betty: maximum price = $95,000 u Trade should occur! Net social surplus on trade = $40,000 u Remember: Our minimum selling price (after 2 years) = $55,000. u Division of surplus to the Wissink’s and to Betty depends on the strike price - what we sell the house for. u Suppose we sold it for $90,000. u HA! u Consumers surplus=$5,000 and Producers surplus=$35,000. u What did we sell it for? u Don’t ask!