Consumer Surplus: the amount a buyer is willing to pay – the amount the buyer actually pays ie. John is willing to pay 100 for an album, Paul 80, Ringo 50, and George 70. In an auction john gets one for 80$, he benefits because he valued it as a 100$ and consumer surplus is 20$.
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-in another example if there were 2 identical copies of the album being auctioned both say sold at 70$, Ringo and George leave, and John and Paul get the albums with 30$ and 10$ surplus respectively
-the “total consumer surplus” in the market would be 40$
Using the Demand Curve to Measure Consumer Surplus
Now we look at how the consumer surplus can be seen on a demand curve example:
Figure 1 : the above mentioned people’s willingness to pay for the album is able to be seen when the demand curve is graphed from the demand schedule made using the prior info on album demand.
-At any quantity, the price given by the demand curve shows the willingness to pay of the marginal buyer (the buyer who would leave the market first if the price were any higher)
ie. ringo leaves as soon as the price rises above 50
We can also see the consumer surplus on the same demand curve graph:
Just like in physics area underneath the graph represents something. In a demand curve it happens to be consumer surplus.
-the lesson from this example holds for all demand curves: “The area below the demand curve and above the price measures the consumer surplus in a market.”
-this is true because the height of the demand curve measures the value buyers place on the good, as measured by their willingness to pay for it
-however, the demand curves we see of markets are much smoother or a curve in shape because the drop from willingness to pay is miniscule due to the large amount of buyers in the market
However Lower Prices Raises Consumer Surplus
-in Figure 3 we see how we are able to see consumer surplus in a hypothetical market with a standard linear demand
-moreover we are able to examine the changes in consumer surplus as price is lowered
Figure 3: as price drops, we move down the demand line and we can see the new consumers that engage in buying and their consumer surplus, along with the new bigger surplus the old initial consumers have.
What Does Consumer Surplus Measure?
-consumer surplus, the amount that buyers are willing to pay for a good minus the amount they actually pay for it, measures the benefit that buyers receive from a good as the buyers themselves perceive it
-therefore, consumer surplus is a good measure of economic wellbeing if policymakers want to respect the preferences of buyers (not always the case, ie. drug dealers/ users)
Producer Surplus (Sellers View):
Cost: the value of everything a seller must give up to produce a good; basically their opportunity cost (ie. painter would be time and supplies needed for job)
Willingness to sell = Cost
-in the producer’s case, the “cost” is the minimum price they can sell it at, or else they are losing money.
Just as the same case as buyers sellers have their own version of surplus
Producer Surplus: amount received by the seller – the seller’s cost of providing it
ie. example revolves around painters, cost would be things like time, paints etc.
Grandma does the job for 600$ her cost is 500$ so her producer surplus is 100$
Figure 4: same scenarios as buyers we can see their costs (willingness to sell) from the market’s supply* curve
-at any quantity, the price given by the supply curve shows the cost of the marginal seller (the seller who would leave the market first if the price were any lower)
Figure 5: as one can see this time looking at the supply curve, it’s the opposite of the consumer version, we take the above area of the graph instead of below it.
-the lesson from this example applies to all supply curves: The area below the price and above the supply curve measures the producer surplus in a market
-height measures seller costs, and the difference between the price and the cost of production is each of the seller’s surplus
How A Higher Prices Raises Producer Surplus
-a price increase (ie. P1 to P2) leads to more quantity being produced then we get new surplus from new producers who enter the market due to higher price, and then some additional surplus to the initial producers
-the point of both these new techniques is the ability to precisely see how much the buyer or the seller benefits from things like price increase / decrease
The Benevolent social planner
-looking at market outcomes let’s say there is someone who want to control the market so that everyone wins how does he go about knowing when that point is; anything can be changed to increase more win for both sides/ economic well-being
-to understand that we look at Total Surplus (the producer surplus + consumer surplus)
Consumer surplus = Value to buyers – Amount paid by buyers
Similarly, we define producer surplus as
Producer surplus = Amount received by sellers – Cost to sellers
When we add consumer and producer surplus together, we obtain
Total Surplus = (Value to buyers – Amount paid by buyers)+(Amount received by sellers – Cost to sellers)
Basically cancelling out the amount of money in circulation and so we find that total surplus is all about the value an item holds to the buyer (willingness to pay) and the cost it takes for the producers to make that item (opp. Cost)
-this leaves us with Total Surplus = Value to Buyers – Cost to Sellers
If an allocation of resources maximizes total surplus, we say that the allocation exhibits efficiency.
Efficiency: resource allocation done in such a way as to maximize the total surplus received by all members of society. < WIN, WIN ideal goal>
-if inefficient, some potential gains from buyers and sellers are not being realized (ie. an allocation is inefficient if a good is not being produced by the sellers with lowest cost. In this case, moving production from a high-cost producer to a low-cost producer will lower the total cost to sellers and raise total surplus
Equality: distributing the economic prosperity to everyone equally
-A pie analogy – the size of the pie you want to maximize is efficiency and the way you slice the pie for everyone is equality
-usually economists only care about efficiency, but policymakers take into account equality
Evaluating the Market Equilibrium
Looking at figure 7 we see that producers at ED line won’t be selling anything since consumers are not willing to buy it at that high a price, and similarly buyers only willing to buy at the prices of the EB line won’t get anything since producers don’t want to go that low.
From this we can say this about market outcomes:
1. Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay
2. Free markets allocate the demand for goods to the sellers who can produce them at the lowest cost
So can the planner do something as allocating more on to the buyers or producers to increase economic well being? NO!
But can he then change the quantity of the item to increase economic well being?
NO! again because:
3. Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.
To explain look at this figure:
Figure 8: if we are starting from a Q greater than the market equilibrium quantity, we can increase total surplus by reducing Q and if it’s at a Q lower than market equilibrium quantity we can again increase total surplus by increasing Q hence returning back to equilibrium point
-so if there is a benevolent planner out there looking for the best economic market outcome, then all he needs to do is let things be and naturally achieve the equilibrium price/quantity point.
As the French say: laissez faire, “Allow them to do”
Made 2 assumptions in this chapter: that markets are perfectly competitive (ie. equal market power) and doesn’t take into account externalities; both may lead to market failure