Welfare Economics

Consumer Surplus and

Producer Surplus
 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 societys
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 receive benefits
from taking part in the market
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
economic welfare of the buyers.
Producer surplus measures economic
welfare of the sellers.

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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
consumers 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 consumers 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
Presleys first album

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I will illustrate consumer surplus through this
 Consumer Surplus
Consumer surplus is the buyers willingness
to pay for a good minus the amount the
buyer actually pays for it.
Example: If the Elvis albums price is $75

Buyer Willingness Consumer Buy?

to Pay Surplus
John 100 25 Yes
Paul 80 5 Yes
George 70 -5 No
Ringo 50 -25 No
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 Market Demand
The market demand shows the
quantities demanded by 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 to Pay
John 100
Schedule Paul 80
George 70
Ringo 50

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 Buyer Willingness to Pay
John 100
Figure 1 The Demand CurvePaul 80
Price of
Album George 70

Johns willingness to pay Ringo 50

$100

80 Pauls willingness to pay

70 Georges willingness to pay

50 Ringos 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
Albums 16

Copyright2003 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 -20 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
Johns willingness to pay Pauls willingness to pay 20
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 commoditysay, a bag of potato
chipsthat provides an unchanging amount of
happiness to the consumer, and
if Johns happiness and Pauls happiness are
comparable, and
if both John and Paul get the same happiness
from a bag of potato chips
Thats a lot of ifs!
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 Price = $70

copies of the Elvis album. The Buyer Willingness

to Pay
governments goal is to give them to John 100
two of the four guys so as to Paul 80

generate the maximum happiness. George 70

Ringo 50
Who will get the governments
copies?
Obviously, John and Paul, same as in
the market outcome we 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
P1 measures the maximum
B C
willingness to pay that
could be obtained from
Q1 units

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
sellers 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 sellers 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 -200 No
Frida 800 -100 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 -100 No
Frida 800 0 No
Georgia 600 200 Yes
Grandma 500 300 Yes

0 1 2 3 4
Grandmas cost Quantity of
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Georgias cost Houses Painted
 Is there a better alternative to
the market system?
If the government had to get two Seller Cost ($)
Mary 900
houses painted, who would get
Frida 800
the job?
Georgia 600
Grandma and Georgia, of course. Grandma 500
And, as we just saw, thats
exactly what happens in the
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
Price of and up to the
House quantity supplied is
Painting Supply the Total Revenue.
Total
producer 2. The area under the
$900 surplus ($500) price and above the
supply is the
800 Producer Surplus.

600 Seller Cost ($) Producer Sell?

Georgias producer Surplus
500 surplus ($200)
Mary 900 -100 No
Frida 800 0 No
Grandmas 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 51
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 52
 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