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Consumer and Producer Surplus

Consumer and Producer Surplus

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02/14/2011

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Economics 101Dr. Smith
Consumer and Producer Surplus
How can we determine if an economic policy (a tax, promoting free trade, a pricefloor, etc.) is “good” or “bad”? Specifically, do we have any objective way of evaluatingthe economic impact of a policy on the market(s) that it affects? The answer, of course, isyes – we do have tools that would aid us in performing this type of analysis. In fact, oneof the most useful tools we have is something known as
Consumer Surplus.
(We willalso develop the producers analog to consumer surplus –
Producer Surplus
.)In order to understand consumer surplus, let’s begin by looking at the market for compactdiscs. The market demand and supply functions are given by the equations below:
P Q
501000
=

P Q
s
50200
+=
Let’s graph these equations, but first let’s turn the demand and supply functions into
inverse demand
and
inverse supply
functions.Inverse Demand:
Q P
501
20
=
Inverse Supply:
Q P
501
4
+=
Now, let’s form the graph:

PQSD12400201000

You will notice that I have labeled the market equilibrium – the equilibrium price is \$12and the equilibrium quantity is 400.How did I find the equilibrium? Set demand equal to supply!In equilibrium, set
s
QQ
=
So,
P  P
50200501000
+=
And
1001200
=
12*
=
P
400)12(501000*
==
Q
Now, let’s turn our attention to the concept of consumer surplus. We will begin with thedefinition:
Consumer Surplus
– Consumer surplus is the difference between what a consumer(s)would have been willing to pay for a certain quantity of a good, and what thatconsumer(s) actually had to pay.To get a firm grasp of what consumer surplus is all about, let’s return to our CD example.If we use our demand function, then we may determine what a consumer would have been willing to pay for the first CD sold in the market - \$19.98. Where does this figurecome from?
Q P
501
20
=
If Q is equal to one, then:98.1902.020)1(20
501
===
P
Therefore, for the first CD a consumer is willing to pay \$19.98. What did that consumer actually have to pay? The equilibrium price of \$12! Therefore, the consumer who waswilling to pay \$19.98 is able to enjoy a “surplus” of \$7.98 (the difference between whatthey were willing to pay \$19.98, and what they had to pay \$12.)The important thing to notice is that there will be surplus of this sort associated withevery CD sold except the very last one! (The 400
th
.) How can we calculate the totalconsumer surplus that is being enjoyed by consumers in the compact disc market?Well, the easiest way to do this is to return to our graph…

I have colored in two areas on our graph. Let’s think about what these areas represent.First, let’s begin with thered rectangle. Thered rectanglehas height of 12 (the equilibrium price) and width of 400 (the equilibrium quantity). Therefore, the area of thered rectanglerepresents the total amount consumers had to spend to buy 400 compactdiscs.Remember, though, that the consumers would have been willing to pay more than the redrectangle in order to acquire the 400 compact discs. How much would consumers have been willing to pay? The demand curve gives us our answer. At any quantity we choosethe demand curve tells us how much consumers would have paid in order to acquire thatCD. Therefore, the total willingness to pay for compact discs is given by the areaunderneath the demand curve. In our example, consumers’ total willingness to pay isrepresented by thered rectangleadded to the blue triangle. So, this brings us back to our key question. How can we calculate the total consumer surplus in this market? We simply need to perform the following calculation:
Consumer surplus
= (Consumers’ total willingness to pay for Q* units; the blue triangleadded to thered rectangle) – (What consumers actually had to pay for Q* units; thered rectangle)CS = (Red Rectangle+Blue Triangle) – Red Rectangle=Blue Triangle Specifically,PQSD12400201000