Lesson 1

Consumer and Producer Surplus

In this chapter we will learn:

The meaning of consumer surplus and its relationship to the demand curve The meaning of producer surplus and its relationship to the supply curve The meaning and importance of total surplus and how it can be used both to measure the gains from trade and to evaluate the efficiency of a market How to use changes in total surplus to measure the deadweight loss of taxes Why the deadweight loss of a tax means that its true cost is more than the amount of tax revenue collected
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Consumer surplus
Willingness to Pay: A consumers willingness to pay for a good is the maximum price at which he or she would buy that good. Its the maximum amount that a buyer will pay for a good. P> willingness to pay: the buyer doesnt buy P< willingness to pay: the buyer will buy

P= willingness to pay: the buyer is indifferent between buying or not the good
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Consumer surplus
Consider this demand curve, with only 5 buyers:
Price 10 Mark

Frank

6 4

Alex

Paul

Guy

Quantity of chocolates

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Consumer surplus
Consumer Surplus: Individual consumer surplus is the net gain to an individual buyer from the purchase of a good. It is equal to the difference between the buyers willingness to pay and the price paid. It is a measure of the benefit a buyer has when participating in the market.
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Consumer surplus
If the price is 5 yuan:
Price
10 Mark Individual surplus

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Frank

Alex 5 Paul 4

Guy

Quantity of chocolates

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Consumer surplus
Total consumer surplus is the sum of the individual consumer surpluses of all the buyers of a good. In our example: (10-5) + (8-5) + (6-5)= 9 yuan. The term consumer surplus is often used to refer to both individual and to total consumer surplus.

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Consumer surplus
When we have many more consumers the demad curve will be smooth, but the surplus analisys is made the same way.

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Consumer surplus
How Changing Prices Affect Consumer Surplus:
Price 10 Mark

8
6

Frank

Alex 5 4 Paul 3 2 Guy

Quantity of chocolates

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Consumer surplus
With the usual demand curve:

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Consumer surplus
Conclusions: The consumer surplus will increase when the price decreases. The consumer surplus will decrease when the price increases.

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Producer Surplus
Consider this supply curve, with only 5 sellers:
P S

10 8 6 C 4 2 A B D

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Producer Surplus
A potential sellers cost is the lowest price at which he or she is willing to sell a good. Individual producer surplus is the net gain to a seller from selling a good. It is equal to the difference between the price received and the sellers cost.

Total producer surplus in a market is the sum of the individual producer surpluses of all the sellers of a good. Economists use the term producer surplus to refer both to individual and to total producer surplus.
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Producer Surplus
Individual surplus: Graph:
P S

A, B or C
Total surplus:

10 8 7 D C 4 2 A B

A + B +C

6
Individual surplus

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Producer Surplus
With many producers:

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Producer Surplus
Changes in Producer Surplus:

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Gains from trade

The total surplus generated in a market is the total net gain to consumers and producers from trading in the market. It is the sum of the producer and the consumer surplus. It is also called Social Surplus. Both consumers and producers are better off participating in the market economy than they would if everyone tried to be self sufficient. Graph:the green area represents the total surplus
Consumers surplus S P

Producers surplus

1000

Quantity

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Efficiency of markets
We have the highest possible surplus when the market is in equilibrium.The competitive equilibrium maximize the sum of consumers and producers surplus.

Any change from the equilibrium will cause a total surplus decrease.
We can try to reallocate the total surplus in 3 different ways.

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Efficiency of markets
1)Reallocate consumption among consumers: Giving the good to B instead of A will decrease the consumer surplus by 10$: 35-30 is lost (-5) and 25 -30 is the negative surplus of B! Totally -5-5=-10 Or: B values the good 25$ while A values it 35$, the surplus loss is 10$.
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Graph:

Efficiency of markets
2) Reallocate sales among sellers: It will lower the producer surplus: if Y sells at 35 and the market price is 30 Y loses 5$ (-5$ surplus), while X that is willing to sell at 25$ will lose 5$ surplus selling at 30$ market price.
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Graph:

Efficiency of markets
3) Change in the quantity traded: If less or more than 1000 units are sold there is a surplus loss. For example if Y sells to B 10$ surplus is lost: Y sells at 35$ but B is willing to pay only 25$. If less that 1000 units are sold, there are transactions that dont occur the surplus coming from those transactions is lost. Graph:

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Efficiency of markets
The market equilibrium maximizes total surplusthe sum of producer and consumer surplus. It does this because the market performs four important functions: 1. It allocates consumption of the good to the potential buyers who value it the most, as indicated by the fact that they have the highest willingness to pay. 2. It allocates sales to the potential sellers who most value the right to sell the good, as indicated by the fact that they have the lowest cost.
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Efficiency of markets
3. It ensures that every consumer who makes a purchase values the good more than every seller who makes a sale, so that all transactions are mutually beneficial.

4. It ensures that every potential buyer who doesnt make a purchase values the good less than every potential seller who doesnt make a sale, so that no mutually beneficial transactions are missed.
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Efficiency of markets
Attention: even if the market maximizes the total surplus this doesnt mean that it is the best outcome for every single consumer or producer. Ceteris Paribus every buyer would like to pay less, and every producer to receive more. Furthermore some people may benefit from price controls and some sellers from price sellers.

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Efficiency cost of a tax

The excess burden, or deadweight loss, from a tax is the extra cost in the form of inefficiency that results because the tax discourages mutually beneficial transactions. Graph:

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Efficiency cost of a tax

Deadweight loss: The area (Tax)xQt is the tax revenue, the yellow triangle represents the pure loss, the deadweight loss of the tax. Graph:

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Efficiency cost of a tax

The greater the elasticity of demand or supply, the greater the fall in the quantity bought and sold caused by the tax.

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