Lecture 8

Inter-relationships between Markets;

Consumer and Producer Surplus
Inter-relationships between markets
• In earlier units, we briefly covered some relationships. In this unit, we
examine these further – such as complements and substitutes – the
relationship between Good A and B.
Complements
• Goods which are demanded together are called complements. They are
in joint demand.
• Economic theory tells us that an increase in quantity demanded for one
complement will lead to an increase in demand for another, resulting
in an increase in the price and quantity bought of the other
complement.
• E.g. for some reason, the price of one complement – strawberries –
falls. There will be an increase in quantity demanded.
• This consequently / subsequently leads to an increase in demand for
another complement – cream. This in turn causes the price of cream to
rise.
Complements
• Here’s another example – two goods –
breakfast cereals and milk.
• For some reason, the supply of breakfast
cereals increases – a rightward shift of the
supply curve. This leads to a fall in the
price for breakfast cereals, and an increase
in quantity demanded for breakfast cereals.
• This consequently / subsequently leads to
an increase in demand for milk as
complementary good, which in turn causes
the price of milk to rise, and quantity of
milk bought to increase.
Substitutes
• Goods which can be replaced by another good are called substitutes.
They are in competitive demand.
• Economic theory tells us that a rise in the price of a good will lead to
an increase in demand and a rise in the price of a substitute good.
Substitutes
• Suppose here – two goods – beef and
pork.
• For some reason, the supply of beef
decreases – a leftward shift of the
supply curve. This leads to a rise in
price of beef, and a decrease in quantity
supplied for beef.
• This consequently / subsequently leads
to an increase in demand for pork as
substitute good, which in turn causes
the price of pork to rise, and quantity of
pork bought to increase.
Derived demand
• There are some goods which are demanded only because they are needed
for the production of other goods.
• We say the demand for these goods a derived demand.
• Economic theory tells us that an increase in demand for a good will lead to
an increase in price and quantity purchased of goods which are in derived
demand from it.
• E.g. the demand for flour is derived in part from the demand for cakes and
bread.
• Or, the demand for sugar is derived in part from the demand for
confectionery and chocolates.
• Or, the demand for steel is derived in part from the demand for cars and
ships. See diagram.
Substitutes
• Suppose here, two goods – cars and steel.
• Left panel clearly shows an increase in
demand for cars (demand curve shifts
rightward). This leads to an increase in
quantity bought and sold.
• Because of an increase in demand for cars,
car manufacturers will have to increase
their demand for steel.
• So, demand curve for steel shifts
rightward. This consequently leads to a rise
in price of steel, and an increase in quantity
bought for steel.
Substitutes
• Let’s try this: timber and wooden furniture. How would you describe
the relationship in terms of demand?
• An increase in demand for wooden furniture will lead to an
increase in quantity bought and sold of wooden furniture. Because
of this increase in demand for wooden furniture, furniture makers
will have to increase their demand for timber. Demand curve for
timber shifts rightward. This consequently leads to a rise in price
of timber, and an increase in quantity bought for timber.
Composite demand
• If a good is demanded for two or more distinct uses, we say the good
is in composite demand.
• E.g. milk is used for yogurt, for cheese making, for butter, for
drinking.
• Or, land is used for residential, industrial, or commercial use.
• Or, steel is demanded for car manufacturing, and for shipbuilding.
• Economic theory tells us that an increase in demand for one composite
good will lead to a fall in supply for another.
Composite demand
• Suppose here – oil used for
chemicals, oil used for petrol.
• An increase in demand by the
chemical industry for oil, will
push the demand curve to the
right, increasing both quantity
sold and the price of oil.
• With an upward sloping supply
for oil as a whole, an increase in
supply of oil to the chemical
industry will reduce the supply of
oil for petrol.
Composite demand
• So, supply curve of oil for petrol
shifts leftward, which causes
price of oil for petrol to rise, and
quantity demanded of oil for
petrol to decrease.
• Economic theory therefore
predicts that an increase in
demand for one good will lead to
a rise in price and fall in quantity
demanded for a good with which
it is in composite demand.
Joint supply
• When one good is supplied for two different purposes, we say a good
is in joint supply.
• Economic theory tells us that an increase in demand for one good in
joint supply will lead to a rise in its price. This leads to an increase in
the quantity supplied.
• The supply of the other good therefore increases, leading to a fall in its
price.
Joint supply
• Suppose here, two goods – beef and
leather.
• An increase in demand for beef
leads to a rise in price and an
increase in quantity bought and sold
of beef.
• More beef production will lead, as a
by-product, to greater supply of
leather.
• So, supply curve of leather shifts
rightward, which results in a fall in
price of leather, and consequent
increase in quantity.
Checkpoint summary
• This unit covers common relationships between any two goods:
complements, substitutes, composite demand, derived demand, joint
supply.
Consumer and Producer Surplus
Consumer and producer surplus
• In this unit, we study the concept of consumer surplus and producer
surplus to understand how buyers and sellers benefit from a
competitive market, and how big these benefits are.
Up for grabs
• ‘Field of Tower’ chess set
designed by Zaha Hadid.
• Specs: carved in resin with a
highly-polished finish; chess
board lacquered and polished
with a silk-screen printed grid;
limited edition.
• How much are you willing to pay
for this?
• How much did you actually pay
for?
Consumer surplus
• The difference between what you are willing to pay (WTP) and what
you actually pay for, is what we call consumer surplus (CS),
sometimes referred to as ‘net gain’ by the consumer.
• Consumer surplus = WTP (buyer’s maximum) – Price (what
buyer actually pays).
• So, an individual buyer will receive individual consumer surplus.
• And the sum of many individual consumer surpluses makes up the
total consumer surplus.
• Let’s look at an example with 5 buyers looking to buy used books.
• Suppose here – the market demand • Krugman, Wells, Graddy. (2013).
Chapter 4: Price Controls and
for used books. Quotas. In Essentials of
Economics (3rd ed.), pp.107. New
• First things first, you may wonder York: Worth Publishers
why the profile of demand curve is
stepped and not smoothly linear.
• This demand curve here is a zoom-
in on the uppermost tip of the linear
market demand curve, made up of
millions of users (quantities).
• At $30 a book, A, B and C will each • Krugman, Wells, Graddy. (2013).
Chapter 4: Price Controls and
buy a book – their WTP is higher Quotas. In Essentials of
than price. Economics (3rd ed.), pp.107. New
York: Worth Publishers
• D and E cannot afford to buy the
book because their WTP is lower
than price.
• So, A, B, and C each gain individual
consumer surplus. And the total
consumer surplus is $49.
• Graphically, consumer surplus is represented by area under demand
curve, and above price.
• Left panel – consumer surplus as the shaded area. Price of iPad is $500.
Some consumers who have a higher WTP (budget) buy the iPad and
receive consumer surplus.
• Krugman, Wells, Graddy. (2013).
Chapter 4: Price Controls and
Quotas. In Essentials of
Economics (3rd ed.), pp.107-108.
New York: Worth Publishers
Sold! Producer Surplus…
• How much is the seller willing to sell the chess set at?
• How much the seller finally settle for?
• The difference between what the seller is willing to sell at (WTS) and
what seller actually receives is called producer surplus (PS), ‘net
gain’ by the producer.
• Producer Surplus = Price (what seller actually receives) – WTS
(seller’s minimum).
• So, an individual seller will receive individual producer surplus.
• And the sum of many individual producer surpluses makes up the
total producer surplus.
• At $30 a book, A, B and C will each • Krugman, Wells, Graddy. (2013).
Chapter 4: Price Controls and
sell a book – the price is higher than Quotas. In Essentials of
their WTS. Economics (3rd ed.), pp.110. New
York: Worth Publishers
• D and E will not sell the book
because the price is lower than their
WTS (their asking price).
• So, A, B, and C each gain individual
producer surplus. And the total
producer surplus is $45.
• Graphically, producer surplus is represented by area above demand
curve, and below price.

• Krugman, Wells, Graddy. (2013).

Chapter 4: Price Controls and
Quotas. In Essentials of
Economics (3rd ed.), pp.111. New
York: Worth Publishers
Surplus vs profit
• Note: there may be confusion between surplus and profit – they are
different.
• A seller can gain 0 producer surplus but positive profit. The seller may
be willing to sell at a price as long as seller’s cost is covered.
• E.g. a pen costs $1 to produce. The seller’s WTS is $5. The seller
secures a transaction of $5. Seller gains 0 producer surplus, but a
profit margin of $4.
Total surplus
• So, in the market for used books,
PE = $30, QE = 1,000 books
bought and sold.
• The sum of total consumer
surplus and total producer
surplus is what we call total
surplus.
• Total surplus on the graph is
represented by the sum of area of
CS and area of PS.
Summary
• We study the concept of consumer surplus and producer surplus to
understand how buyers and sellers benefit from a competitive market,
and how big these benefits are.
• Consumer surplus is the difference between what you are willing to
pay (think of it like budget), and what you actually paid for.
• Producer surplus is the difference between what producer is willing to
sell at – for sure enough to cover cost – and what producer actually
receives from the sale.
Readings and assignment
• Essential – please read Unit 13 of textbook.
• Anderton, Alain. (2015). Unit 13: Interrelationships between markets. In
Economics (6th ed.), pp.76-80. UK: Anderton Press Ltd.
• Assignment
• Please attempt the unit questions in the textbook.