Welfare Economics

Consumer Surplus and Producer Surplus

 Reading Material
• See the “Consumer and Producer Surplus” subsection of the
“Costs and Benefits of a Tariff” section of Chapter 9 (“The
Instruments of Trade Policy”) of International Economics:
Theory and Policy, 10th edition, by Paul Krugman, Maurice
Obstfeld, and Marc Melitz

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 Revisiting The Market Equilibrium
• The theory of supply and demand shows how markets allocate
scarce resources among competing needs.
• But are the equilibrium price and the equilibrium quantity the
right price and the right quantity from society’s point of view?
• This question takes us into welfare economics.

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 Welfare Economics
• Welfare economics is the study of how the allocation of
resources affects economic well-being
• It shows that:
– Both buyers and sellers gain from all the buying and selling
– The equilibrium outcome in the theory of supply and demand
maximizes the total welfare of buyers and sellers

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 Two main concepts
• When buyers and sellers trade willingly, it must be because
they expect to benefit
• Consumer surplus measures what the buyers gain.
• Producer surplus measures what the sellers gain.

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CONSUMER SURPLUS

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 Willingness to pay
• To define consumer surplus we first need to define
“willingness to pay.”
• Willingness to pay is the maximum amount that a buyer will
pay for a good.
• It measures how much the buyer values the good.

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 Willingness to pay: background
• Assume there is a commodity such that every additional unit
of it increases a consumer’s happiness by the same amount
– In other words, the consumption of additional units of this
commodity induces neither boredom nor addiction
– Possible examples: Potato chips? Candy?
• Then the consumer’s willingness to pay for a product is a good
measure of the happiness that he or she gets from it

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 Willingness to pay: background
• Suppose a bag of potato chips provides a fixed amount of
happiness
• If your willingness to pay is
– 4 bags of potato chips for a shirt, and
– 2 bags of potato chips for a cup of coffee, then
– one can safely say that the shirt makes you twice as happy as the cup
of coffee
• So, your willingness to pay for a commodity is a good measure
of how much you like it
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 Willingness to pay: background
• If the dollar price of a bag of potato chips is known, willingness
to pay in the example above can also be expressed in dollars

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 Willingness to pay: background
• Another example:
– if you are willing to pay $15 for a shirt, and
– if a bag of potato chips
• always gives you 3 “haps” of happiness, and
• sells at the price of $0.50 each, then
– the shirt gives you 90 “haps” of happiness.

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 Willingness to pay: background
• In other words, your willingness to pay for the shirt is
– a monetary measure of the happiness you get from the shirt, and
– it is proportional to the happiness you get from the shirt, as
measured in “haps”

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 Table 1 Four Possible Buyers’ Willingness to Pay

For a mint-condition
recording of Elvis
Presley’s first album

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I will illustrate consumer surplus through this extended example.
 Consumer Surplus
• Consumer surplus is the buyer’s willingness to pay for a good minus the
amount the buyer actually pays for it.
– Example: If the Elvis album’s price is $75…

Buyer Willingness to Pay Consumer Surplus Buy?

John 100 25 Yes

Paul 80 5 Yes
George 70 0 No
Ringo 50 0 No
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 Market Demand
• The market demand shows the total quantity demanded by all
buyers at different prices.
• We can use the willingness-to-pay numbers to calculate the
market demand
– See the next slide

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 Buyer Willingness

The Demand Schedule

to Pay
John 100
Paul 80
George 70
Ringo 50

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 Buyer Willingness to Pay

Figure 1 The Demand Curve

John 100

Price of Paul 80
Album George 70

$100 John’s willingness to pay Ringo 50

80 Paul’s willingness to pay

70 George’s willingness to pay

50 Ringo’s willingness to pay

The height of the

demand curve at any
quantity shows the
Demand willingness to pay of
whoever bought the
last unit.

0 1 2 3 4 Quantity of
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Albums
Copyright©2003 Southwestern/Thomson Learning
Area of a Rectangle

Area = Width × Height Height

Width
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Figure 2 Measuring Consumer Surplus with the
Demand Curve Buyer Willingness Consumer Buy?
to Pay Surplus
John 100 30 Yes
(b) Price = $70.01
Paul 80 10 Yes
Price of
Album George 70 0 No
$100 Ringo 50 0 No

1. The area under the demand

80 curve measures the total
willingness to pay for the
70
quantity demanded.

50 2. It is also the maximum

willingness to pay that could
be generated from that
quantity.

Demand

0 1 2 3 4 Quantity of
Albums
John’s willingness to pay Paul’s willingness to pay 19
 Interpersonal comparability
• We just saw
– that the total area under the demand curve is $180, and
– that is also the total willingness to pay of John and Paul
• But can we say it is the total happiness of John and Paul?

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 Interpersonal comparability
• Yes,
– if there is a commodity—say, a bag of potato chips—that provides an
unchanging amount of happiness to the consumer, and
– if John’s happiness and Paul’s happiness are comparable, and
– if both John and Paul get the same happiness from a bag of potato
chips
• That’s a lot of if’s!
• But we will make these simplifying assumption anyway
– Not just for John and Paul, but for everybody

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 Utilitarianism
• The idea that
– the happiness of an individual can be measured numerically,
– the happiness of a group of people can be measured numerically,
– the happiness of a group of people is simply the sum of the numbers
representing the happiness of the individual members of the group, and
that
– social policy should seek to maximize the total happiness of society,
– is called utilitarianism
• Welfare analysis in this course takes utilitarianism as its guiding
philosophy
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 The market and the planner
• Suppose the government has two copies of the Elvis album. Price = $70

The government’s goal is to give them to two of the four guys

Buyer Willingness
to Pay

so as to generate the maximum happiness. John 100

Paul 80
• Who will get the government’s copies? George 70

• Obviously, John and Paul, same as in the market outcome we

Ringo 50

saw before.
• So, the market does the best that the government could have
done

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 Willingness to Pay from the Demand Curve

Price
A

The area under the demand

curve measures the total
willingness to pay of the
consumers who bought Q1 units.
It also measures the maximum
willingness to pay that could be
P1 obtained from Q1 units
B C

Demand

0 Q1 Quantity
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 Using the demand curve to measure willingness to pay

• In general, the area under the demand curve up to the

quantity demanded is a graphical measure of the total
willingness to pay of the buyers.
• It is also the maximum willingness to pay that can be obtained
from that quantity
– That is, the government could not give away that quantity in a way
that generates higher willingness to pay.

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Figure 3 How the Price Affects Consumer Surplus
(a) Consumer Surplus at Price P
Price
A
Consumer Surplus (ABC) +
Total Payment (OBCQ1) =
Willingness to Pay (OACQ1)

Consumer
surplus
P1
B C

Total
Payment
Demand

0 Q1 Quantity
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Using the Demand Curve to Measure Consumer Surplus

• In general, the area below the demand curve and above the
price measures the consumer surplus.

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Figure 3 How the Price Affects Consumer Surplus
(b) Consumer Surplus at Price P
Price
A

Initial
consumer
surplus
C Consumer surplus
P1
B to new consumers

F
P2
D E
Additional consumer Demand
surplus to initial
consumers
0 Q1 Q2 Quantity
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 Shifts in Demand
• We know that the demand curve can shift, for reasons such as
– a change in tastes, and
– a change in the prices of related goods
• Given that the demand for a product can shift as a result of a
change in the price of a related good, does it make sense to
say that the area under the demand curve measures the
happiness consumers get from the product?

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 Shifts in Demand
• Continued from the previous slide
• Yes!
– Keep in mind that the area under the demand curve is a monetary measure of the
happiness obtained by buyers
– The objective or psychological happiness obtained from a shirt may be unchanged even
if the monetary willingness to pay for the shirt changes, perhaps because of a change in
the price of a related good
• In an earlier slide, a bag of potato chips was assumed to always provide 3 “haps”
of happiness, and sold at a price of $0.50. Consequently, consumers were wiling
to pay $15 for a shirt that provided 90 “haps” of happiness.
• It follows that if the price of a bag of potato chips rises to $1, consumers would
then be willing to pay $30 for the same shirt, leading to an upward shift in the
demand curve for shirts.

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PRODUCER SURPLUS

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 Producer Surplus
• Producer surplus is the amount a seller is paid for a good minus
the seller’s cost.
• It measures the net benefit to sellers
• It is almost but not quite the same as profit.

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 Cost of production
• The cost of production is the market value of all resources
used in production
– By all, I do mean all.
– Even if some resources used in production were obtained for free,
their market value must be included in cost.

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Table 2 The Cost of Painting a House for Four
Possible Sellers

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 Costs → Supply
• The supply of house painting services shows the quantity of
house painting services supplied at all possible prices
• The cost numbers in the previous slide can be used to calculate
supply of house painting services

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 Costs → Supply

Seller Cost ($)

Mary 900
Frida 800
Georgia 600
Grandma 500

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Figure 4 The Supply Schedule and the Supply Curve

Seller Cost ($)

Mary 900
The height of the supply curve Frida 800
at any quantity shows the
Georgia 600
production cost to whoever
produces the last unit. Grandma 500

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 Producer Surplus
• Producer surplus is the amount a seller is paid minus the seller’s cost
– Example: If the going price for getting a house painted is $700 we get the
following table.

Seller Cost ($) Producer Sell?

Surplus
Mary 900 0 No
Frida 800 0 No
Georgia 600 100 Yes
Grandma 500 200 Yes
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Using the Supply Curve to Measure Producer Surplus

• The area below the price and above the supply curve measures
the producer surplus.

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Figure 5 Measuring Producer Surplus with the Supply Curve
(b) Price = $799.99
1. The area under
Price of the supply curve is
House the cost of the
Painting Supply quantity supplied
2. It is also the
lowest cost for that
$900 quantity
800

Seller Cost ($) Producer Sell?

600
Surplus
500
Mary 900 0 No
Frida 800 0 No
Georgia 600 200 Yes
Grandma 500 300 Yes

0 1 2 3 4
Grandma’s cost Quantity of
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Georgia’s cost Houses Painted
 Is there a better alternative to the market system?
• If the government had to get two houses painted, who would Seller Cost ($)

get the job? Mary 900

Frida 800
• Grandma and Georgia, of course. Georgia 600

• And, as we just saw, that’s exactly what happens in the Grandma 500

market outcome.
• So, the market achieves the best that the government could
have achieved

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Figure 5 Measuring Producer Surplus with the Supply Curve
(b) Price = $800 1. The rectangular area
under the price and up
Price of to the quantity supplied
House is the Total Revenue.
Painting Supply
Total
producer 2. The area under the
$900 surplus ($500) price and above the
supply is the Producer
800 Surplus.

600 Seller Cost ($) Producer Sell?

Georgia ’s producer Surplus
500 surplus ($200)
Mary 900 0 No
Frida 800 0 No
Grandma ’s producer Georgia 600 200 Yes
surplus ($300)
Grandma 500 300 Yes

0 1 2 3 4
Quantity of
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Houses Painted
Figure 6 How the Price Affects Producer Surplus
(a) Producer Surplus at Price P

Price
Supply

B
P1
C
Producer
surplus
Total Revenue (OBCQ1) =
Production Cost (OACQ1) +
Producer Surplus (ABC)
Production
A Cost

0 Q1 Quantity 43
Figure 6 How the Price Affects Producer Surplus
(b) Producer Surplus at Price P

Price
Additional producer Supply
surplus to initial
producers

D E
P2 F

B
P1
Initial C
Producer surplus
producer to new producers
surplus

0 Q1 Q2 Quantity 44
 Figure 7 Consumer and Producer Surplus in the
Market Equilibrium
Price A

D
Supply

Consumer
surplus

Equilibrium E
price
Producer
surplus

Demand
B

0 Equilibrium Quantity
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quantity