Economic Analysis Economic Analysis for Businessfor Business

Session IX: Consumer Session IX: Consumer Surplus, Producer Surplus Surplus, Producer Surplus and Market Efficiency-1and Market Efficiency-1InstructorInstructorSandeep BasnyatSandeep Basnyat98418922819841892281Sandeep_basnyat@yahooSandeep_basnyat@yahoo.com.com

Welfare EconomicsWelfare EconomicsWelfare 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 SURPLUSCONSUMER SURPLUSWillingness 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 CurveWTP and the Demand Curve

Derive the demand schedule:

4John, Chad, Anthony, Flea

0 – 125

3Chad, Anthony, Flea

126 – 175

2Anthony, Flea176 – 250

1Flea251 – 300

0nobody$301 & up

Qdwho buysP (price of iPod)

name WTP

Anthony $250

Chad 175

Flea 300

John 125

$0

$50

$100

$150

$200

$250

$300

$350

0 1 2 3 4

WTP and the Staircase shaped WTP and the Staircase shaped Demand CurveDemand Curve

P Qd

$301 & up 0

251 – 300 1

176 – 250 2

126 – 175 3

0 – 125 4

P

Q

$0

$50

$100

$150

$200

$250

$300

$350

0 1 2 3 4

WTP and the Staircase Demand CurveWTP 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 WTP

Anthony’s WTP

Chad’s WTPJohn’s WTP

Mathematical Calculation of Consumer Mathematical Calculation of Consumer Surplus (CS)Surplus (CS)Consumer surplus is the amount a buyer is willing to pay minus the buyer actually pays:

CS = WTP – P

name WTP

Anthony $250

Chad 175

Flea 300

John 125

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.

$0

$50

$100

$150

$200

$250

$300

$350

0 1 2 3 4

CS and the Demand CurveCS and the Demand CurveP

Q

Flea’s WTP P = $260

Flea’s CS = $300 – 260 = $40

Total CS = $40

$0

$50

$100

$150

$200

$250

$300

$350

0 1 2 3 4

CS and the Demand CurveCS and the Demand CurveP

Q

Flea’s WTP

Anthony’s WTP

Instead, suppose P = $220

Flea’s CS = $300 – 220 = $80

Anthony’s CS =$250 – 220 = $30

Total CS = $110

$0

$50

$100

$150

$200

$250

$300

$350

0 1 2 3 4

Lessons from CS and the Demand Lessons from CS and the Demand CurveCurve

P

Q

The lesson:

Total CS equals the area under

the demand curve above the price,

from 0 to Q.

0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

Further Calculations of CS with Smooth D Further Calculations of CS with Smooth D CurveCurve

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 heightHeight of this triangle is $60 – 30 = $30. So, CS = ½ x 15 x $30 = $225.

h

$

0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

How a Higher Price Reduces How a Higher Price Reduces CSCS

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

AA CC TT II VV E LE L EE AA RR NN II NN G G 11: : Consumer surplusConsumer surplus

05

10152025

303540

4550

0 5 10 15 20 25

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

AA CC TT II VV E LE L EE AA RR NN II NN G G 11: : AnswersAnswers

05

10152025

303540

4550

0 5 10 15 20 25

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 SURPLUSPRODUCER SURPLUSProducer 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 CurveCost and the Supply Curve

335 & up

220 – 34

110 – 19

0$0 – 9

QsPDerive the supply schedule from the cost data:

name cost

Angelo $10

Hunter 20

Kitty 35

CHAPTER 7 CONSUMERS,

PRODUCERS, EFFICIENCY OF MARKETS

Cost and the Supply CurveCost and the Supply Curve

$0

$10

$20

$30

$40

0 1 2 3

P

Q

P Qs

$0 – 9 0

10 – 19 1

20 – 34 2

35 & up 3

CHAPTER 7 CONSUMERS,

PRODUCERS, EFFICIENCY OF MARKETS

$0

$10

$20

$30

$40

0 1 2 3

Cost and the Supply CurveCost 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

$0

$10

$20

$30

$40

0 1 2 3

Producer SurplusProducer Surplus

P

Q

Producer surplus (PS): the amount a seller is paid for a good minus the seller’s cost.

PS = P – cost

$0

$10

$20

$30

$40

0 1 2 3

Producer Surplus and the S CurveProducer 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.

0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

PS with Lots of Sellers & a Smooth S PS with Lots of Sellers & a Smooth S CurveCurve

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

0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

How a Lower Price Reduces How a Lower Price Reduces PSPSIf 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 sellersgetting lower P

Total SurplusTotal 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 Evaluating the Market EquilibriumEquilibrium

Market eq’m: P = $30 Q = 15,000Total surplus = CS + PS

0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

S

D

CS

PS

Market EfficiencyMarket 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 Does Eq’m QQ Maximize Total Maximize Total Surplus?Surplus?

0

10

20

30

40

50

60

0 5 10 15 20 25 30

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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