Micro-App week 1

Consumer and Producer Surplus

Consumer surplus refers to the difference between the amount consumers would be willing to pay
for a good (often called willingness-to-pay) and the amount they actually have to pay for the good.
For example, if you are willing to pay 10 euro for a pizza, but the pizza is only 5 euro, the difference is
considered a surplus that accrues to you as a consumer.

Producer surplus: refers to the difference between the amount producers are willing to sell their
goods for and the amount they actually receive for their goods. For example, a bakery may be willing
to produce an apple pie whenever the market price is 3 euro. If the actual market price for an apple
pie is 5 euro, the positive difference is a surplus that accrues to the bakery
(Surplus = overschot)

A consumer (producer) will never choose to consume (produce) a good when the consumer
(producer) surplus us negative. In the example above, if the market price of a pizza was 15 euro
instead, you would simply refrain from purchasing the pizza.
Each consumer (producer) in the market thus has either positive or zero consumer
(producer) surplus. Adding up all these consumer (producer) surpluses yields the total consumer
(producer) surplus in a market. This adding up is, of course, quite a time-consuming task. Isn’t there
an easier way? It turns out that we can also determine total consumer and producer surplus by
making use of the demand function and supply function in a market.

Consider the following numerical example. Since the examples of pizzas and apple pies make us feel
hungry, let’s focus on a non-food market: the market for canal boat cruises in Groningen. Suppose
that demand looks as follows:
QD = 6,000 – 100P where:
- QD = Quantity demanded of boat cruises
- P = The price of a boat cruise

The supply of boat cruises in Groningen is as follows:

QS = 50P where:
- QS = The quantity supplied

From now on, we will abbreviate consumer surplus and producer surplus as CS and PS.
Our interest in CS and PS when the market for canal boat cruises in Groningen is in equilibrium. We
will make use of a graph to visualize the analysis, whereby we place the price P on the vertical axis
and the quantity Q on the horizontal axis. To plot the demand- and supply function in this graph, we
need to rewrite the function with respect to the variable that is on the vertical axis (the price). That
is, we are interested in the inverse demand- and supply function.

Rewriting the demand functions yields the inverse demand function:

P = 60 – 1/100QD

The inverse supply function:

P = 1/50QS

By plugging in different values of Q in the functions, we can determine the shape of the inverse
demand curve and the inverse supply curve. Drawing a line through the different points gives the
inverse demand curve and the inverse supply curve.
The market equilibrium is at the point where the inverse demand- and supply curve intersect. That
is, where the quantity demanded is equal to the quantity supplied: QD = QS

So: substituting the demand function and the supply function yields:
6000 – 100P = 50P
-150P = -6000
P = 40
The equilibrium price in the market for canal boat cruises in Groningen therefore is: P = 40
At this price the quantity demanded is exactly equal to the quantity supplied.
Having determined the market equilibrium, the key question of this recap is what benefits
accrue to the consumer and producers in this market? It turns out that CS and PS can be visualized in
the constructed graph.

CS is the area underneath the inverse demand curve and above the market price. The section of the
inverse demand curve above the market price captures all consumers with a willingness-to-pay
above or equal to the market price.
PS is the area underneath the market price and above the inverse supply curve. The section of the
inverse supply curve underneath the market price captures all suppliers who are willing to supply
boat cruises at a price lower or equal than the market price. Since the market price is higher than (or
equal to) these suppliers’ ‘’minimum price’’, the suppliers choose to supply boat cruises, and they
will receive producer surplus in return.
How can we calculate the size of consumer and producer surplus?
The most straightforward way is to use the derived graph and to calculate the size of CS area and the
PS area. In order to do so, multiply the length of each area with the width of each area.

For example:
For CS the length is 60 – 40 = 20 and the width is 2000 – 0 = 2000
CS = ½ (60 – 40)(2000 – 0)= 20000
PS= ½(40 – 0)(2000 – 0) = 40000

Having found CS and PS, the next step is to determine total surplus (TS) in the market. Fortunately,
this can be done easily by summing CS and PS:
TS = CS + PS

For example:
TS = 20000 + 40000 = 60000

Demand, Supply, and the Market Equilibrium

A market is characterized by a product or service that is bought and sold at a particular location and
time. For example, the market for Dutch pancakes (a product) in Groningen (a location) today (a
timeframe). A market is thus defined by three characteristics:
1. A product or service
2. A particular location
3. A specific timeframe
In each market, there are two groups: those who purchase the product or service (consumers) and
those who supply the product or service (suppliers). The former captures the demand side of the
market, whereas the latter describes the supply side. In this recap, we will first discuss demand in
more detail. We then continue with supply, and conclude with a discussion on when a market is in a
so-called market equilibrium. For brevity, we will use the term ‘good’ to describe a product or
service.
Demand is the combined amount of a good that consumers are willing to buy. Demand can be
affected by many factors, varying from the price of the good to consumer income and prices of other
goods. Which factors affect demand in what way is summarized in a demand function (demand
curve), which describes (visualized) the mathematical relationship between demand and the relevant
factors.
Let’s consider the example of Dutch pancakes again. Suppose that demand for these pancakes, which
we will denote with QD, is only affected by the price P of these pancakes. Suppose, furthermore, that
the demand function looks as follows: QD = 1000 – 200P. note the minus sign in front of the term P,
which yields an intuitive interpretation: if the price of pancakes goes up, demand goes down.
We would like to visualize the demand function in a graph. Economists typically place the
price P on the vertical axis, and the quantity demanded Q D on the horizontal axis. To plot the demand
function, we thus need to rewrite the demand function with respect to the variable that is on the
vertical axis (the prices). This yields the so-called inverse demand function: P = 5 – 1/200QD
By plugging different values of QD we can get the corresponding values of P. If Q D = 200, P will be P =
4. If QD = 400, P will be P=3, et cetera. These points can be drawn in the graph mentioned earlier.
Drawing a line through the points yields the inverse demand curve:
Note that P = 5, the quantity demanded is zero: Q D = 0 the price at which the quantity demanded is
zero is referred to as the choke price. The inverse demand curve is downward-sloping: higher prices
mean lower quantities of pancakes demanded.
A change in the price triggers a so-called movement along the demand curve. If the price increases,
the quantity demanded moves along the line in a north-westerly direction. If the price decreases, the
quantity demanded moves along the line in a south-easterly direction.
At this stage, you may argue that the demand function we have used thus far is a bit simplistic. In
reality, the demand for Dutch pancakes may not only depend on the price of pancakes, but also, for
example, on consumer income, which we can denote with I. Consumers with higher (lower) income
are likely to demand more (less) pancakes.
Let’s focus again on the case with consumer income I. Suppose that we can account for I by updating
the demand function in the following way:
QD = 1000 – 200P + I
Note that consumer income I enters the function with a positive sign (+): higher income increases
demand for pancakes. The inverse demand function becomes:
P = 5 – 1/200QD + 1/200I
How to visualize changes in I in the graph to the right? Note that I is not on the vertical- or horizontal
axis. Any change in I will therefore lead to a so-called shift in demand, whereby the entire demand
curve moves. The reason why the entire curve moves is because it holds for every price level P. even
when the price remains unchanged, demand can thus change because of changes in consumer
income.

To illustrate the previous discussion, consider the following numerical example. If I = 0, we are left
with the old inverse demand function: P = 5 – 1/200QD. If income increases to I = 400, the inverse
demand function becomes: P = 7 – 1/200QD. There is an outward shift of the inverse demand curve:
Note that a change in I changes the vertical intercept (the choke price), but not the slope of the
inverse demand curve. At any given initial price, demand for pancakes is now higher. For example,
when the price is P = 4, the demand is QD = 200 when I = 0, but QD = 600 when I = 400.
The key take-away from this discussion is that the demand function is flexible and can be easily
adjusted to reflect influences from factors other than the price of the good. A change in the price of
the good will induce a movement along the demand curve, whereas a change in any other factor will
trigger the entire demand curve to shift.
Supply refers to the combined amount of a good that all producers in a market are willing to sell. Just
like demand, supply can be affected by many factors. Which factors affect supply in what way is
summarized in a supply function (supply curve), which describes (visualizes) the mathematical
relationship between supply and the factors that affect supply.
Having discussed both the demand side- and the supply side of the market, we can now focus
on the market equilibrium: the point where demand equals supply. A market equilibrium occurs
when the market price yields a quantity demanded that is exactly equal to the quantity supplied. To
evaluate the equilibrium in market for Dutch pancakes, let’s first recall the simple inverse demand-
and supply function that we derived earlier: P = 5 – 1/200QD and P = 1/300QS
The inverse demand- and supply functions can be plotted in a graph with the price P on the vertical
axis and the quantity demanded/supplied Q on the horizontal axis:

The point where the two lines intersect is the market equilibrium. The challenge is to find the
corresponding coordinates that pin down this equilibrium: the equilibrium price P* and the
equilibrium quantity Q*.
In order to derive the market equilibrium, the key thing to note is that the quantity demanded equals
the quantity supplied in equilibrium: QD = QS. This equality allows us to find the coordinates.

First, rewrite the inverse functions for QD and QS. That is, retrieve the original demand- and supply
functions again.
This yields: QD = 1000 – 200P and QS = 300P. eq
Equating Yields: QD = QS  1000 – 200P = 300P
Solving P for yields the market equilibrium price: P* = 2
*
So if P = 2 the market is in equilibrium and the quantity demanded will equal the quantity supplied.
The equilibrium quantity Q* is easily found by substituting P* in either the demand- or supply
function.
Elasticities:
The price elasticity of demand/supply refers to the percentage change in the quantity
demanded/supplied divided by the percentage change in the price. It provides an answer to the
following question: if the price changes with 1 percent, what will be the percentage change in the
quantity demanded/supplied.

Week 2:
There are four assumptions about consumer preferences:
1. Transitivity: which means that choices among goods are not logically consistent.
2. Completeness and rankability: this mean that consumers can make comparisons across all
sets of goods that they consider.
3. More of a good is preferred to less: two cookies are better than one.
4. Dimishing marginal utility: the more a consumer has of a particular good, the less she is
willing to give up for something else to get even more of that good.

When the utility function of a consumer is known, one straightforward way of calculating the
marginal utility is by taking the first order partial derivative. In case of partial differentiation, we only
differentiate the relevant variable and treat other variables as constants.
Achmeds utility function over Haagse hopjes and Drentse turfjes is given in the exercise:
U(H, D) = 3H + 2D
Let’s first calculate the marginal utility associated with Haagse hopjes
H: MUH = U’/H’
Lecture Utility
You have some Money, how many apples and bananas will you buy?
- Depends on preferences, how much do you like A(ppels) relative to B(ananas)?
- Probably you won’t spend all your money on one fruit.
- Depends on your budget.
- Depends on the prices of the products.

The four crucial assumptions over consumer preferences:

1. Completeness: You can compare bundles and decide which you like most.
2. Non-satiation: The more you get of something, the better.
3. Transitivity: If you prefer bundle A over bundle B, and bundle B over bundle C, you should
also prefer bundle A over C.
4. Diminishing marginal utility: The more you have of a particular good, the less you care about
getting yet another unit.

Utility is a measure of how happy consumers are.

A utility function describes the relationship between what consumers consume and their level of
well-being.

If your preferences satisfy the four criteria mentioned earlier, they can be represented by a utility
function.
The value of your utility functions as such does not really mean much. Comparing your utility for
different bundles does make sense: a utility of 8 (Bundle A) is better than an utility that gives 6
(Bundle B). But you can’t say bundle A makes me 1/3 more happy than bundle B. Utility is an ordinal
ranking rather than a cardinal ranking.