SM 300

Engineering Economics
 Producer Surplus

Producer Surplus = The value of the difference between the actual

selling price of a product and the price producers are willing to
sell it for on the supply curve.
 Market Equilibrium
• Equilibrium (or market clearing) price: Price that equates the
quantity supplied to the quantity demanded.
• Market mechanism: Tendency in a free market for price to change
until the market clears.
• Surplus: Situation in which the quantity supplied exceeds the
quantity demanded.
• Shortage: Situation in which the quantity demanded exceeds the
quantity supplied
The market clears at price P0
and quantity Q0.

At the higher price P1, a

surplus develops, so price falls.

At the lower price P2, there is a

shortage, so price is bid up.
Changes in Market Equilibrium

Given the Demand function

and Supply function,
the point of intersection of
the two functions will give the
Market Equilibrium Price and
Quantity.
 Market Efficiency and Deadweight Loss
Deadweight Loss = The net loss of consumer and producer surplus for
underproduction or overproduction of a product.

• The total net benefit, or total surplus = the entire triangle consisting of the
consumer and producer surplus triangles.
• Underproduction leads to market inefficiency because the deadweight loss
(gray triangle ABE) is no longer earned by either consumers or producers.
• Overproduction leads to market inefficiency because too many resources
are devoted to this product and a deadweight loss of area EDC occurs.
 Diamond-Water Paradox Revisited

• (a) shows the marginal utility per carat you receive from each diamond
consumed, and (b) represents marginal utility per gallon of water
consumed….. The vertical line, S, in each graph is the supply of
diamonds or water available per year.
As per Law of Diminishing Marginal Utility…
Since water is much more plentiful than diamonds, the supply for water
intersects the marginal utility curve at MUw ~= zero…Conversely,
the supply for diamonds intersects the marginal utility curve at a much
higher marginal utility, MUd.
 Diamond-Water Paradox Revisited (Contd.)

Now, for consumer equilibrium… MUw / Pw = MUd / Pd

i.e. MUw/MUd = Pw/Pd
Because of the relative marginal utilities of water and diamonds, you
are willing to pay much more for one more carat of a diamond
than for one more gallon of water.