Consumer and Producer Surplus

In an un-regulated market, buyers and

sellers buy and sell at the prevailing
market price. But, for some consumers the
value of the good exceeds this market
price. Consumer surplus is equal to the
shaded area between market price and
demand curve (Fig. 8.1).
Producers too enjoy a benefit i.e. the
difference between the market price the
producers receives and the marginal cost
of producing this unit. Producer surplus is
equal to the shaded area between the
market price and the supply curve (Fig.
8.1)

 Welfare

Effects
of
Government
Intervention
Consumer surplus measures the total net
benefit to consumers, and thereby measure
the gain or loss to consumers from a
government intervention
Producer surplus measures the total net
benefit to producers, and thereby measure
the gain or loss to producers from a
government intervention

 Application

of Consumer and Producer

Surplus
With government intervention, the price
gets reduced as well as production. This
results in excess demand
Change in consumer surplus: The net
change
in consumer surplus is equal to A B (Fig.
8.2)
The rectangle A is larger than triangle B,
therefore net change in consumer surplus
is positive

Change in Producer Surplus: With price

controls, some producers will stay in the
market but will receive a lower price for
their output, while other producers will
leave the market. The triangle C is the
additional loss for those producers who
have left the market and those who have
stayed but are producing less. Therefore,
the total loss is A C

Deadweight Loss: The loss to producers is

much more than the gain to consumers
(Fig8.2). This is known as deadweight loss.
The change in consumer surplus is A B and
the change in producer surplus is -A C. The
total change in surplus is therefore (A B)+
(- A C)= - B C, which is given by the two
triangles B and C. The deadweight loss
reflects an inefficiency
caused by price
controls, the loss in producer surplus
exceeds the gain in consumer gain.
( Example. 8.1, Oil price controls leading to
gasoline shortages)

 The

Efficiency of a Competitive Market:

Economic efficiency implies the maximiza

tion of aggregate consumer and producer
surplus. A deadweight loss does not always
mean that a policy is bad, it may fulfill other
important objectives.
Market Failure: market failure occurs because
prices fail to provide the proper signals to consu
mers and producers. The unregulated competitive market is inefficient because it does
not maximise aggregate consumer and producer
surplus

Market failure can occur because of:

Externalities- externalities are costs and benefits that do not show

up as part of the market price (e.g. cost to society of environmental
pollution)
Lack of Information: market failure can also occur when consumers
lack information about the quality or nature of a product, and
therefore cannot make utility-maximizing purchasing decisions. Govt.
intervention in the form of labeling may correct the failure
In the absence of externalities or lack of information, an
unregulated competitive market does lead to the economically
efficient output level
In Fig. 8.5, the price P2 is fixed above the market clearing price
Po. At a higher price, Q3 will be demanded and hence consumer
loss is equal to B and producer loss is equal to C. The total
deadweight loss B and C gives an optimistic assessment of the
efficiency cost of policies that force price above market clearing
levels (govt. might buy the unsold output or declares a support
price)

 Minimum

Price
Government policies sometimes seeks to
raise prices above market-clearing levels,
rather than lower them (minimum wage
law, resulting in unemployment Fig.8.8)
Government intervention in
the form of minimum price can reduce
producers profits because of the cost of
excess production (Fig. 8.7)

 Price

Support and Production Quotas

The Government sets the market price of
a
good above the free-market level and
buys
up whatever output is needed to maintain
that price. The Government can also
increase
prices by restricting production, either
direct
ly or through incentives to producers

Price Supports: Under a Price Support Programme, the govt. sets a support price,
say
Ps in Fig.8.9, and then buys up whatever
output is needed to keep the market
price
at this level. Impact of Price Support on:
Consumers- consumers lose by an amount
CS = -A B
Producers- producers gain by an amount
PS = A + B + D

The Government: there is also a cost to the

government which must be paid for by
taxes,
and ultimately be borne by consumers.
The cost is equal to (Q2 Q1)Ps in Fig 8.9.
The cost may be reduced if the government
can sell them abroad at a lower price.
The total welfare cost of the policy:
CS + PS Cost to Govt
=D (Q2 Q1)Ps

Production Quotas

The government can also cause the price of

a good to rise by reducing supply. It can do
this by setting quotas on how much each
firm can produce (e.g. control of liquor licences by state governments). In this case the
deadweight loss is equal to triangles B and C. It
would be better if Government gives additional
income to farmers equal to A + B + D than giving
price supports costing consumers A + B
(Fig. 8.10)

The

Impact of a Tax or
Subsidy
Tax
What would happen to the price of widgets if
the government imposed a $1 tax on every
widget sold?
The burden of a tax falls partly on a consumer
and partly on a producer

After the imposition of a tax, the price the

buyer pays must exceed the net price the
seller receives by t cents (Fig. 8.15)
Before the imposition of the tax Po and Qo
represent the market price and quantity.
After the imposition of a tax Pb is the price
the buyer pays and Ps is the net price the
seller receives
Buyers lose A + B, sellers lose D + C, and
the Govt. earns A + D in revenue. The
deadweight loss is B + C

If demand is relatively elastic and supply is

relatively inelastic, the burden of the tax
will fall more on sellers, and vice versa
In general, a tax falls mostly on the buyer if
Ed/Es is small, and mostly on the seller if
Ed/Es is large
When the pass-through fraction (Es/Es Ed)
is 1 (totally inelastic), all the tax is borne by
consumers. When the pass-through is
zero(totally elastic), all the tax is borne by
producers

Subsidy
A subsidy can be taken as a negative tax.
Like a tax a subsidy is split between buyers
and sellers, depending on the relative
elasticities of supply and demand
With a subsidy, the sellers price exceeds
the buyers price, and the difference
between the two is the subsidy.
In general, the benefit of a subsidy accrues
mostly to buyers if Ed/Es is small and
mostly to sellers if Ed/Es is large (8.17)