1. Consumer Surplus and Producer Surplus
Welfare Economics
Consumer Surplus and Producer Surplus

2. 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

3. 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.

4. 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

5. 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.

6. Consumer surplus

7. 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.

8. 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

9. 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

10. 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

11. 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.

12. 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”

13. 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.

14. 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

15. 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

16. The Demand Schedule Buyer Willingness to Pay John 100 Paul 80 George70
Ringo 50
The Demand Schedule

17. 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

18. Area of a Rectangle
Area = Width × Height
Height
Width

19. 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

20. 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?

21. 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

22. 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

23. 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

24. 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

25. 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.

26. 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

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

28. 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

29. 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.

30. 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.

31. Producer surplus

32. 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.

33. 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.

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

35. 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

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

37. 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.

38. 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

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

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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