Economic Analysis for Business Session IX: Consumer Surplus, Producer Surplus and Market Efficiency-1 Instructor Sandeep Basnyat

Welfare Economics Welfare economics is the study of how the allocation of resources affects economic well-being. Buyers and sellers receive benefits from taking part in the market. ◦ Consumer surplus measures economic welfare from the buyer’s side. ◦ Producer surplus measures economic welfare from the seller’s side. The equilibrium in a market maximizes the total welfare of buyers and sellers.

CONSUMER SURPLUS Willingness to pay is the maximum amount that a buyer will pay for a good. It measures how much the buyer values the good or service. Consumer surplus is the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it. It’s the benefit that buyers receive from their own perspective.

CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS WTP and the Demand Curve Derive the demand schedule: 4 John, Chad, Anthony, Flea 0 – Chad, Anthony, Flea 126 – 175 2Anthony, Flea176 – 250 1Flea251 – 300 0nobody$301 & up QdQd who buys P (price of iPod) nameWTP Anthony$250 Chad175 Flea300 John125

WTP and the Staircase shaped Demand Curve PQdQd $301 & up0 251 – – – – 1254 P Q

WTP and the Staircase Demand Curve At any Q, the height of the D curve is the WTP of the marginal buyer, the buyer who would leave the market if P were any higher. P Q Flea’s WTPAnthony’s WTPChad’s WTPJohn’s WTP

Mathematical Calculation of Consumer Surplus (CS) Consumer surplus is the amount a buyer is willing to pay minus the buyer actually pays: CS = WTP – P nameWTP Anthony$250 Chad175 Flea300 John125 Suppose P = $260. Flea’s CS = $300 – 260 = $40. The others get no CS because they do not buy an iPod at this price. Total CS = $40.

CS and the Demand Curve P Q Flea’s WTP P = $260 Flea’s CS = $300 – 260 = $40 Total CS = $40

CS and the Demand Curve P Q Flea’s WTPAnthony’s WTP Instead, suppose P = $220 Flea’s CS = $300 – 220 = $80 Anthony’s CS = $250 – 220 = $30 Total CS = $110

Lessons from CS and the Demand Curve P Q The lesson: Total CS equals the area under the demand curve above the price, from 0 to Q.

P Q Further Calculations of CS with Smooth D Curve The demand for shoes D CS is the area b/w P and the D curve, from 0 to Q. Recall: area of a triangle equals ½ x base x height Height of this triangle is $60 – 30 = $30. So, CS = ½ x 15 x $30 = $225. h $

P Q How a Higher Price Reduces CS D If P rises to $40, CS = ½ x 10 x $20 = $100. Two reasons for the fall in CS. 1. Fall in CS due to buyers leaving market 2. Fall in CS due to remaining buyers paying higher P

A C T I V E L E A R N I N G 1 : Consumer surplus P $ Q demand curve A. Find CS for P = $30. Suppose P falls to $20. How much will CS increase due to… B. buyers entering the market C. existing buyers paying lower price

A C T I V E L E A R N I N G 1 : Answers P $ Q demand curve A. CS = ½ x 10 x $10 = $50 P falls to $20. B. CS for the additional buyers = ½ x 10 x $10 = $50 C. Increase in CS on initial 10 units = 10 x $10 = $100

PRODUCER SURPLUS Producer surplus is the amount a seller is paid for a good minus the seller’s cost. It measures the benefit to sellers participating in a market. Its the benefit that producers receive from their own perspective.

Cost and the Supply Curve 335 & up 220 – – 19 0$0 – 9 QsQs P Derive the supply schedule from the cost data: namecost Angelo$10 Hunter20 Kitty35

CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS Cost and the Supply Curve P Q PQsQs $0 – – – & up3

CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS Cost and the Supply Curve P Q At each Q, the height of the S curve is the cost of the marginal seller, the seller who would leave the market if the price were any lower. Kitty’s cost Hunter’s cost Angelo’s cost

Producer Surplus P Q Producer surplus (PS): the amount a seller is paid for a good minus the seller’s cost. PS = P – cost

Producer Surplus and the S Curve P Q PS = P – cost Suppose P = $25. Angelo’s PS = $15 Hunter’s PS = $5 Kitty’s PS = $0 Total PS = $20 Kitty’s cost Hunter’s cost Angelo’s cost Total PS equals the area above the supply curve under the price, from 0 to Q.

P Q PS with Lots of Sellers & a Smooth S Curve The supply of shoes S PS is the area b/w P and the S curve, from 0 to Q. The height of this triangle is $40 – 15 = $25. So, PS = ½ x b x h = ½ x 25 x $25 = $312.5 h

P Q How a Lower Price Reduces PS If P falls to $30, PS = ½ x 15 x $15 = $112.5 Two reasons for the fall in PS. S 1. Fall in PS due to sellers leaving market 2. Fall in PS due to remaining sellers getting lower P

Total Surplus Total surplus = Consumer surplus + Producer surplus = Value to buyers – Amount paid by buyers + Amount received by sellers – Cost to sellers Total surplus = Value to buyers – Cost to sellers Represents the entire area between the maximum price that buyers want to pay and the lowest cost that sellers would incur.

Evaluating the Market Equilibrium Market eq’m: P = $30 Q = 15,000 Total surplus = CS + PS P Q S D CS PS

Market Efficiency Market is considered efficient if it maximizes the total surplus Maximizing total surplus: Maximizing consumer surplus by involving maximum number of consumers in the market for trade + Maximizing producer surplus by involving maximum number of producers in the market for trade

Does Eq’m Q Maximize Total Surplus? P Q S D At Q = 20, cost of producing the marginal unit is $35 But consumers wants to pay only $20. Since there is an excess supply, some sellers will not be able to sell, causing total surplus to decrease. So, decreasing production will increase the Total Surplus.

Thank you