1. CONSUMER SURPLUS, PRODUCER SURPLUS, AND THE EFFICIENCY OF MARKETS

2. Overview Two types of analysis:
Positive Analysis: Addresses what is -- uses theory and models to predict observable and testable tendencies in economic relationships
Minimum Wage laws cause unemployment
Price ceilings cause shortages
Normative Analysis: Addresses what should (or ought to) be -- depends on value judgments.
The minimum wage should be higher
Taxes should be lower 2

3. Overview Up to this point we have focused on positive analysis.
Now we turn to normative analysis
In other words we will examine how changes in prices and government intervention affect economic well-being and ask question such as: “What price is the “right” price in a market?”
Answering such question falls under the umbrella of welfare economics.
Welfare Economics: refers to how the allocation of resources affects economic well-being.

4. Overview
The main concepts of welfare economics are consumer and producer surplus.
Consumer surplus measures economic welfare from the buyer’s side.
Producer surplus measures economic welfare from the seller’s side.

5. Consumer Surplus How much do consumers value a good or service?
Economists use the concept of willingness to pay to answer that question.
Willingness to pay is the maximum amount that a buyer will pay for a good.
Willingness-to-Pay (WTP) is closely related to Demand.

6. Willingness to Pay Schedule
Consider the willingness to pay of four individuals for airline tickets to Cancun for spring break
Consumer A B C D
Willingness to Pay
$200
$140
$160
$100

7. Demand Schedule Price More than 200 $160 - $200 $140 - $160
$120 - $140
$100 or less
Buyers A
A + B
A + B + C
A + B + C +D
Quantity Demanded 1 2 3 4

8. “Step” Demand Curve Demand Price $200 A’s willingness to pay 160
B’s willingness to pay
140
C’s willingness to pay
100
D’s willingness to pay 1 2 3 4
Quantity of Tickets
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9. Consumer surplus = WTP – Price
CONSUMER SURPLUS: a measure of the benefits enjoyed by buyers in a market.
Consumer surplus = WTP – Price

10. Consumer Surplus Demand P = $180 Consumer Surplus = $20 P = $150
Price
Demand
200
P = $180
Consumer Surplus = $20
P = $150
Consumer Surplus = $50 + $10 = $60
160
140
100
P = $100
Consumer Surplus =
$100 + $ = $200 1 2 3 4
Quantity of Tickets
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11. Consumer Surplus: Typical Demand Curve
Consumer surplus at P1
(Area under Demand Curve, above Price)
Price
Additional consumer surplus to existing customers P1
Additional consumer surplus to new customers P2 D Q1 Q2
Quantity

12. 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.
Cost is minimum price a potential seller would accept for a good
Cost is closely related to Supply

13. Cost Schedule
Consider the cost facing four airlines for flying a passenger to Cancun for spring break.
Firm E F G H
Cost
$50
$110
$220
$300

14. Supply Schedule Price Less than $50 $50 - $100 $110 - $200 $220 - $299
$300 or More
Sellers E
E + F
E + F + G
E + F + G +H
Quantity Supplied 1 2 3 4

15. “Step” Supply Curve H’s Cost G’s Cost F’s Cost E’s Cost Price 300 220
110
F’s Cost 50
E’s Cost 1 2 3 4
Quantity

16. Producer Surplus
PRODUCER SURPLUS: a measure of the benefits enjoyed by sellers in a market.
Closely related to PROFIT
Producer Surplus = Price – Cost

17. Producer Surplus P = $250 Producer Surplus = $200 + $140 + $30= $370
Price
300
P = $250
Producer Surplus = $200 + $ $30= $370
220
P = $150
Producer Surplus = $100 + $40 = $140
110
P = $80
Producer Surplus = $30 50 1 2 3 4
Quantity

18. Producer Surplus: Typical Supply Curve
Additional producer surplus to existing suppliers
Producer surplus at P1 (Area above Supply Curve, below Price) P S P2
Additional producer surplus to new suppliers P1 Q1 Q2 Q

19. Total surplus = Value to buyers – Cost to sellers
Market Efficiency
Consumer surplus and producer surplus may be used to address the following question:
Is the allocation of resources determined by free markets in any way desirable?
Consumer Surplus = Value to Buyers – Price Paid
Producer Surplus = Price Received - Cost to Sellers
Total Surplus = Consumer Surplus + Producer Surplus
Total surplus = Value to buyers – Cost to sellers

20. Market Efficiency
Efficiency is the property of a resource allocation of maximizing the total surplus received by all members of society.
If an allocation of resources is efficient it is impossible to make anyone better off without making someone else worse off
Major Point:
The equilibrium in a competitive market maximizes the total welfare of buyers and sellers.

21. Consumer and Producer Surplus in Market Equilibrium
Price
Supply
Consumer Surplus
Producer Surplus P1
Demand Q1
Quantity

22. Why Equilibrium is Efficient
Price
Supply
Demand
Value to
buyers
Cost to
sellers
Equilibrium
quantity
Cost to
sellers
Value to
buyers
Quantity
Value to buyers is greater
than cost to sellers.
Value to buyers is less
than cost to sellers.
Copyright©2003 Southwestern/Thomson Learning

23. Why Equilibrium is Efficient
Price
A = loss in consumer surplus from under production.
Supply
B = loss in producer surplus from under production.
D = loss in producer surplus from over production A D P1 B C
C = loss in consumer surplus from over production
Demand Q2 Q1 Q3
Quantity