welfare economics consumer surplus and producer surplus
TRANSCRIPT
Welfare Economics
Consumer Surplus and Producer Surplus
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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.
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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
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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.
CONSUMER SURPLUS
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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.
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
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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 it8
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
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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.
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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”
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Table 1 Four Possible Buyers’ Willingness to Pay
For a mint-condition recording of Elvis Presley’s first album
12I will illustrate consumer surplus through this extended example.
Consumer Surplus
Buyer Willingness to Pay Consumer Surplus
Buy?
John 100 25 YesPaul 80 5 YesGeorge 70 -5 NoRingo 50 -25 No
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• 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…
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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
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The Demand ScheduleBuyer Willingness
to Pay
John 100
Paul 80
George 70
Ringo 50
Figure 1 The Demand Curve
Copyright©2003 Southwestern/Thomson Learning
Price ofAlbum
0 Quantity ofAlbums
Demand
1 2 3 4
$100 John’s willingness to pay
80 Paul’s willingness to pay
70 George’s willingness to pay
50 Ringo’s willingness to pay
Buyer Willingness to Pay
John 100
Paul 80
George 70
Ringo 50
The height of the demand curve at any quantity shows the willingness to pay of whoever bought the last unit.
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Area of a Rectangle
Height
Width
Area = Width × Height
Figure 2 Measuring Consumer Surplus with the Demand Curve
(b) Price = $70.01Price of
Album
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70
80
0
$100
Demand
1 2 3 4 Quantity ofAlbums
Buyer Willingness to Pay
Consumer Surplus
Buy?
John 100 30 Yes
Paul 80 10 Yes
George 70 0 No
Ringo 50 -20 No
John’s willingness to pay Paul’s willingness to pay
1. The area under the demand curve measures the total willingness to pay for the quantity demanded.
2. It is also the maximum willingness to pay that could be generated from that quantity.
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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?
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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
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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 philosophy23
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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
Willingness to Pay from the Demand Curve
Quantity
Price
0
Demand
P1
Q1
B
A
C
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
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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.
Figure 3 How the Price Affects Consumer Surplus
Consumersurplus
Quantity
(a) Consumer Surplus at Price P
Price
0
Demand
P1
Q1
B
A
C
Total Payment
Consumer Surplus (ABC) + Total Payment (OBCQ1) = Willingness to Pay (OACQ1)
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Using the Demand Curve to Measure Consumer Surplus
• In general, the area below the demand curve and above the price measures the consumer surplus.
Figure 3 How the Price Affects Consumer Surplus
Initialconsumer
surplus
Quantity
(b) Consumer Surplus at Price P
Price
0
Demand
A
BC
D EF
P1
Q1
P2
Q2
Consumer surplusto new consumers
Additional consumersurplus to initial consumers
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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?
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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 $30 for the same shirt, leading to an upward shift in the demand curve for shirts.
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PRODUCER SURPLUS
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Producer Surplus• Producer surplus is the amount a seller is paid
for a good minus the seller’s cost. • It measures the net benefit to sellers• It is almost but not quite the same as profit.
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Cost of production
• The cost of production is the market value of all resources used in production– By all, I do mean all. – Even if some resources used in production were
obtained for free, their market value must be included in cost.
Table 2 The Cost of Painting a House for Four Possible Sellers
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Costs → Supply
• The supply of house painting services shows the quantity of house painting services supplied at all possible prices
• The cost numbers in the previous slide can be used to calculate supply of house painting services
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Costs → Supply
Seller Cost ($)
Mary 900
Frida 800
Georgia 600
Grandma 500
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.
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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 No
Georgia 600 100 Yes
Grandma 500 200 Yes
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Using the Supply Curve to Measure Producer Surplus• The area below the price and above the supply
curve measures the producer surplus.
Figure 5 Measuring Producer Surplus with the Supply Curve
Quantity ofHouses Painted
Price ofHouse
Painting
500
800
$900
0
600
1 2 3 4
(b) Price = $799.99
Supply
Seller Cost ($) Producer Surplus
Sell?
Mary 900 -100 No
Frida 800 0 No
Georgia 600 200 Yes
Grandma 500 300 Yes
Grandma’s costGeorgia’s cost
1. The area under the supply curve is the cost of the quantity supplied
2. It is also the lowest cost for that quantity
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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 ($)
Mary 900
Frida 800
Georgia 600
Grandma 500
Seller Cost ($) Producer Surplus
Sell?
Mary 900 -100 No
Frida 800 0 No
Georgia 600 200 Yes
Grandma 500 300 Yes
Figure 5 Measuring Producer Surplus with the Supply Curve
Quantity ofHouses Painted
Price ofHouse
Painting
500
800
$900
0
600
1 2 3 4
(b) Price = $800
Georgia’s producersurplus ($200)
Totalproducersurplus ($500)
Grandma’s producersurplus ($300)
Supply
1. The rectangular area under the price and up to the quantity supplied is the Total Revenue.
2. The area under the price and above the supply is the Producer Surplus.
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Figure 6 How the Price Affects Producer Surplus
Producersurplus
Quantity
(a) Producer Surplus at Price P
Price
0
Supply
B
A
C
Q1
P1
Production Cost
Total Revenue (OBCQ1) =Production Cost (OACQ1) + Producer Surplus (ABC)
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Figure 6 How the Price Affects Producer Surplus
Quantity
(b) Producer Surplus at Price P
Price
0
P1B
C
Supply
A
Initialproducersurplus
Q1
P2
Q2
Producer surplusto new producers
Additional producersurplus to initialproducers
D EF
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Figure 7 Consumer and Producer Surplus in the Market Equilibrium
Producersurplus
Consumersurplus
Price
0 Quantity
Equilibriumprice
Equilibriumquantity
Supply
Demand
A
C
B
D
E
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