1. Economic Analysis for Business Session IX: Consumer Surplus, Producer Surplus and Market Efficiency-1 Instructor Sandeep Basnyat 9841892281Sandeep_basnyat@yahoo.com

2. 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.

3. 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.

4. CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS WTP and the Demand Curve Derive the demand schedule: 4 John, Chad, Anthony, Flea 0 – 125 3 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

5. WTP and the Staircase shaped Demand Curve PQdQd $301 & up0 251 – 3001 176 – 2502 126 – 1753 0 – 1254 P Q

6. 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

7. 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.

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

9. 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

10. 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.

11. 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 $

12. 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

13. 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

14. 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

15. 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.

16. Cost and the Supply Curve 335 & up 220 – 34 110 – 19 0$0 – 9 QsQs P Derive the supply schedule from the cost data: namecost Angelo$10 Hunter20 Kitty35

17. CHAPTER 7 CONSUMERS, PRODUCERS, EFFICIENCY OF MARKETS Cost and the Supply Curve P Q PQsQs $0 – 90 10 – 191 20 – 342 35 & up3

18. 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

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

20. 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.

21. 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

22. 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

23. 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.

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

25. 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

26. 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.

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