Transcript Slide 1

Economic Analysis
for Business
Session IX: Consumer Surplus,
Producer Surplus and Market
Efficiency-1
Instructor
Sandeep Basnyat
9841892281
[email protected]
Welfare Economics

Welfare economics is the study of how the
allocation of resources affects economic
well-being.
 Buyers and sellers receive benefits from
taking part in the market.
◦ Consumer surplus measures economic
welfare from the buyer’s side.
◦ Producer surplus measures economic welfare
from the seller’s side.

The equilibrium in a market maximizes the
total welfare of buyers and sellers.
CONSUMER SURPLUS
Willingness to pay is the maximum amount
that a buyer will pay for a good.
 It measures how much the buyer values
the good or service.
 Consumer surplus is the buyer’s willingness
to pay for a good minus the amount the
buyer actually pays for it.
 It’s the benefit that buyers receive from
their own perspective.

WTP and the Demand Curve
Derive the
demand
schedule:
P (price
of iPod)
who buys
Qd
$301 & up nobody
0
251 – 300 Flea
1
Anthony $250
176 – 250 Anthony, Flea
2
Chad
175
3
Flea
300
Chad, Anthony,
126 – 175
Flea
John, Chad,
0 – 125
Anthony, Flea
4
name
John
WTP
125
CHAPTER 7 CONSUMERS,
PRODUCERS, EFFICIENCY
OF MARKETS
WTP and the Staircase shaped Demand Curve
P
$350
$300
P
Qd
$250
$200
$301 & up
0
251 – 300
1
$150
176 – 250
2
$100
$50
126 – 175
3
0 – 125
4
$0
Q
0
1
2
3
4
WTP and the Staircase Demand Curve
P
Flea’s WTP
$350
$300
Anthony’s WTP
$250
$200
Chad’s WTP
John’s
WTP
$150
$100
$50
$0
Q
0
1
2
3
4
At any Q,
the height of
the D curve is the
WTP of the
marginal buyer,
the buyer who
would leave the
market if P were
any higher.
Mathematical Calculation of Consumer Surplus (CS)
Consumer surplus is the amount a buyer is willing to
pay minus the buyer actually pays:
CS = WTP – P
name
WTP
Anthony $250
Suppose P = $260.
Flea’s CS = $300 – 260 = $40.
Chad
175
Flea
300
The others get no CS because
they do not buy an iPod at this
price.
John
125
Total CS = $40.
CS and the Demand Curve
P
P = $260
Flea’s WTP
$350
$300
Flea’s CS =
$300 – 260 = $40
$250
$200
Total CS = $40
$150
$100
$50
$0
Q
0
1
2
3
4
CS and the Demand Curve
P
Flea’s WTP
$350
$300
Anthony’s WTP
$250
$200
Instead, suppose
P = $220
Flea’s CS =
$300 – 220 = $80
Anthony’s CS =
$250 – 220 = $30
$150
Total CS = $110
$100
$50
$0
Q
0
1
2
3
4
Lessons from CS and the Demand Curve
P
The lesson:
Total CS equals
the area under
the demand curve
above the price,
from 0 to Q.
$350
$300
$250
$200
$150
$100
$50
$0
Q
0
1
2
3
4
Further Calculations of CS with Smooth D Curve
CS is the area b/w
P and the D curve,
from 0 to Q.
Recall: area of
a triangle equals
½ x base x height
Height of
this triangle is
$60 – 30 = $30.
So,
CS = ½ x 15 x $30
= $225.
P
The demand for shoes
$ 60
50
h
40
30
20
10
D
Q
0
0
5 10 15 20 25 30
How a Higher Price Reduces CS
If P rises to $40,
CS = ½ x 10 x $20
= $100.
Two reasons for the
fall in CS.
P
60
50
1. Fall in CS
due to buyers
leaving market
40
30
2. Fall in CS due to
remaining buyers
paying higher P
20
10
D
Q
0
0
5 10 15 20 25 30
ACTIVE LEARNING
1:
demand curve
Consumer surplus
P
50
$ 45
A. Find CS for
P = $30.
40
35
Suppose P falls to $20. 30
25
How much will CS
20
increase due to…
15
B. buyers entering
10
the market
5
C. existing buyers
0
paying lower price
0
5
10
15
20
Q
25
ACTIVE LEARNING
Answers
1:
P
50
$ 45
A. CS = ½ x 10 x $10
40
= $50
35
30
P falls to $20.
25
20
B. CS for the
15
additional buyers
10
= ½ x 10 x $10 = $50
5
C. Increase in CS
0
on initial 10 units
0
= 10 x $10 = $100
demand curve
5
10
15
20
Q
25
PRODUCER SURPLUS
Producer surplus is the amount a seller is
paid for a good minus the seller’s cost.
 It measures the benefit to sellers
participating in a market.
 Its the benefit that producers receive
from their own perspective.

Cost and the Supply Curve
Derive the supply schedule
from the cost data:
name
cost
Angelo
$10
Hunter
20
Kitty
35
P
Qs
$0 – 9
0
10 – 19
1
20 – 34
2
35 & up
3
Cost and the Supply Curve
P
$40
$30
$20
$10
$0
Q
0
1
2
3
CHAPTER 7 CONSUMERS,
PRODUCERS, EFFICIENCY
OF MARKETS
P
Qs
$0 – 9
0
10 – 19
1
20 – 34
2
35 & up
3
Cost and the Supply Curve
P
$40
Kitty’s
cost
$30
$20
Hunter’s
cost
$10
Angelo’s cost
$0
Q
0
1
2
3
CHAPTER 7 CONSUMERS,
PRODUCERS, EFFICIENCY
OF MARKETS
At each Q, the
height of the S curve
is the cost of the
marginal seller,
the seller who would
leave the market if
the price were any
lower.
Producer Surplus
PS = P – cost
P
$40
Producer surplus (PS):
the amount a seller
is paid for a good
minus the seller’s cost.
$30
$20
$10
$0
Q
0
1
2
3
Producer Surplus and the S Curve
PS = P – cost
P
$40
Kitty’s
cost
$30
$20
Hunter’s
cost
$10
Angelo’s cost
$0
Q
0
1
2
3
Suppose P = $25.
Angelo’s PS = $15
Hunter’s PS = $5
Kitty’s PS = $0
Total PS = $20
Total PS equals the
area above the supply
curve under the price,
from 0 to Q.
PS with Lots of Sellers & a Smooth S Curve
PS is the area b/w
P and the S curve,
from 0 to Q.
The height of this
triangle is
$40 – 15 = $25.
P
The supply of shoes
60
S
50
40
30
h
20
So,
PS = ½ x b x h
= ½ x 25 x $25 10
= $312.5
0
Q
0
5 10 15 20 25 30
How a Lower Price Reduces PS
If P falls to $30,
PS = ½ x 15 x $15 60
= $112.5
Two reasons for
the fall in PS.
P
50
1. Fall in PS
due to sellers
leaving market
S
40
30
2. Fall in PS due to
remaining sellers
getting lower P
20
10
Q
0
0
5 10 15 20 25 30
Total Surplus
Total surplus
= Consumer surplus + Producer surplus
= Value to buyers – Amount paid by buyers +
Amount received by sellers – Cost to sellers
Total surplus = Value to buyers – Cost to sellers

Represents the entire area between the
maximum price that buyers want to pay and the
lowest cost that sellers would incur.
Evaluating the Market Equilibrium
Market eq’m:
P = $30
Q = 15,000
Total surplus
= CS + PS
P
60
S
50
40
CS
30
PS
20
10
D
Q
0
0
5 10 15 20 25 30
Market Efficiency
Market is considered efficient if it maximizes the
total surplus
 Maximizing total surplus:
Maximizing consumer surplus by involving maximum
number of consumers in the market for trade
+
Maximizing producer surplus by involving maximum
number of producers in the market for trade

Does Eq’m Q Maximize Total Surplus?
At Q = 20,
cost of producing
the marginal unit
is $35
P
60
S
50
But consumers
40
wants to pay only $20.
Since there is an excess 30
supply, some sellers will
20
not be able to sell,
causing total surplus to 10
decrease.
0
So, decreasing production
0
will increase the Total
Surplus.
D
Q
5 10 15 20 25 30
Thank you