INTRODUCTION TO ECONOMICS I

PROF. DR. ÇİĞDEM BÖRKE TUNALI

LESSON 4: CONSUMERS, PRODUCERS AND
MARKETS
Aim

The aim of this course is to explain consumer

surplus, producer surplus and market efficiency
What do We Learn?

 In this lesson we will be explaining;

 Consumer surplus
 Measuring consumer surplus by using demand curve
 Producer surplus
 Measuring producer surplus by using supply curve
 Market Efficiency
Introduction
 When people go to stores to buy goods and services they usually want to
pay less because, if they pay less they would be able to buy more goods
and services.
 Similarly, sellers want to be paid more for their goods and services because
if they can sell their goods and services at higher prices their profit would be
higher as well.
 In our previous lessons, we explained that the prices of goods and services
and the quantities sold is determined by supply and demand.
 However, we did not discuss whether the way markets allocate scarce
resources are desirable or not.
 This means our analysis is positive (what is) rather than normative (what
should be)
 In this lesson, we investigate what benefits consumers and producers obtain
by engaging market transactions and how allocation of resources
influences welfare.
Consumer Surplus

 Let’s start what benefits consumers gain when they make market transactions.
 Suppose that we attend an art auction in which valuable paintings are sold.
 There are five buyers in this auction: Ahmet, Ali, Mehmet, Ayça and Begüm.
 In this auction, there is one painting of Van Gogh and all buyers want to buy
this painting.
 Each of these buyers has a limit
on the amount he/she is willing to pay for this
painting.
Consumer Surplus
 The table below shows the maximum price that each of the five buyers
would pay.
 The maximum price that a buyer would pay is called her/his willingness to
pay and this measures how much that buyer values the good.
 Each buyer would like to buy the painting at a price less than his/her
willingness to pay and he/she would refuse to pay a price greater than
his/her willingness to pay
 At a price equals to his/her willingness to pay the buyer would be indifferent
about buying the painting: the buyer would be equally happy buying the
painting or keeping his/her money.
Buyers Willingness to pay
Ahmet 5000 $
Ali 4000
Mehmet 3000
Ayça 2500
Begüm 2000
Consumer Surplus

 In the auction the bidding process starts at a low price, for example 500 $
 Since all buyers are eager to pay much more the price rises quickly.
 The bidding stops when Ahmet bids 4000 $ (or slightly more). At this point
Begüm, Ayça, Mehmet and Ali have dropped out of the bidding because
they are unwilling to bid any more than 4000 $.
 As it is seen the painting would be bought by the buyer who values it most.
 What benefit does Ahmet get by buying the painting?
 Remember, Ahmet is willing to pay 5000 $ for the painting and he was able
to buy it by paying 4000 $.
 So, Ahmet receives consumer surplus of 1000 $ (5000 – 4000 = 1000)
Consumer Surplus
 What is consumer surplus?
 Consumer surplus is the amount a buyer is willing to pay for a good minus the
amount the buyer actually pays for it.
 Actually, consumer surplus measures the benefit buyers obtain from joining a
market.
 In our example, Ahmet obtains 1000 $ benefit by joining the auction.
 The other consumers do not get consumer surplus because they didn’t buy the
painting.
 Now, let’s assume that there are two Van Gogh paintings.
 In this case, the bidding stops when Ahmet and Ali bid 3000 $ (or sightly higher)
 At this price, Ahmet and Ali are happy to buy one painting.
 Mehmet, Ayça and Begüm are not willing to bid any higher.
 In this situation, Ahmet’s consumer surplus is 5000 – 3000 = 2000 $ and Ali’s
consumer surplus is 4000 – 3000 = 1000 $.
Consumer Surplus

 Ahmet’s consumer surplus is higher than the previous case. Because in this
case, he buys the painting by paying less. (3000 $ instead of 4000 $).
 The total consumer surplus is calculated by summing Ahmet’s and Ali’s
consumer surpluses.
 Total Consumer Surplus = 2000 + 1000 = 3000 $
Measuring Consumer Surplus by Using
the Demand Curve
 There is a close relationship between consumer surplus and the demand
curve.
 In order to explain this let’s consider our previous example.
 As it is seen from the table below, if the price of the painting is above 5000
$ the quantity demanded is zero because there is no buyer who is willing to
pay more than 5000 $ in the market.
 If the price is between 4000 $ and Buyers Willingness to pay
5000 $ the quantity demanded is 1 Ahmet 5000 $
because only Ahmet is willing to buy Ali 4000
at that price. Mehmet 3000
Ayça 2500
Begüm 2000
Measuring Consumer Surplus by Using
the Demand Curve
 If the price is between 3000 $ and 4000 $ the quantity demanded is 2.
Because Ahmet and Ali are willing to buy at that price.
 If the price is between 2500 $ and 3000 $ the quantity demanded is 3.
Because Ahmet, Ali and Mehmet are willing to buy at that price.
 By going on this way, we can find the demand schedule and draw the
demand curve for the painting.
Buyers Willingness to pay
Ahmet 5000 $
Ali 4000
Mehmet 3000
Ayça 2500
Begüm 2000
 Measuring Consumer Surplus by Using the
Demand Curve
a

Demand Schedule
Price Quantity Demanded Buyers Willingness to pay
More than 5000 $ 0 Ahmet 5000 $
4000 $ to 5000 $ 1 Ali 4000
3000 $ to 4000 $ 2 Mehmet 3000
2500 $ to 3000 $ 3 Ayça 2500
2000 $ to 2500 $ 4 Begüm 2000
2000 $ or less 5
 Measuring Consumer Surplus by Using the
Demand Curve
 This graph shows the demand curve that corresponds to
the demand schedule.
 At any quantity, the price given by the demand curve Price
İndicates the willingness to pay of the marginal buyer.
 Marjinal buyer is the buyer who would leave 5000
the market first if the price were any higher. 4000
Demand Schedule 3000
2500
Price Quantity Demanded
2000
More than 5000 $ 0
4000 $ to 5000 $ 1
Demand
3000 $ to 4000 $ 2
0 1 2 3 4 5
2500 $ to 3000 $ 3 Quantity
2000 $ to 2500 $ 4
2000 $ or less 5
 Measuring Consumer Surplus by Using the
Demand Curve
Price
 For example, at the quantity of 3 paintings
the height of the demand curve is 2500 $.
5000
 This is the price that Ayça (marginal buyer)
4000
is willing to pay in order to buy a painting. 3000
 Demand curve can also be used to calculate 2500
2000
the consumer surplus.
 Consumer surplus is the area above the price and
Demand
below the demand curve.
0 1 2 3 4 5
 When the price is 4000 $ the quantity demanded is 1. Quantity
Since the consumer surplus equals the area above the price and below the demand
curve (the purple rectangle) it is (5000 – 4000) x (1-0) = 1000 x 1 = 1000
Measuring Consumer Surplus by Using the
Demand Curve
 When the price is 3000 $ the quantity demanded Price
İs 2.
 In this case, consumer surplus is the total area 5000
of the purple and blue rectangles. 4000
3000
 Hence, consumer surplus is
2500
(5000 – 3000) x (1 – 0) = 2000
2000
(4000 – 3000) x (2 – 1) = 1000
2000 + 1000 = 3000 Demand
0 1 2 3 4 5
Quantity
Measuring Consumer Surplus by Using
the Demand Curve

Rule: Consumer surplus is the area below the demand curve and
above the price.
Consumer Surplus and Economic Well-
Being
 We’ve already learned the consumer surplus.
 Now we can ask the following question?
 Is consumer surplus a good measure of economic well-being?
Consumer Surplus and Economic Well-
Being
 Remember, consumer surplus equals the amount that buyers are willing to
pay for a good minus the amount they actually pay for it.
 Consumer surplus measures the benefit that buyers get from a good as the
buyers perceive on their own.
 So, it’s a good measure of economic well-being if policymakers want to
satisfy the preferences of buyers.
 In many markets consumer surplus reflects economic well-being.
 In economic analyses, it is assumed that buyers are rational.
 Rational people do the best they can in order to achieve their objectives.
 So, consumers’ evaluations are the best way to determine the benefit they
get from the goods they buy.
Quick Quiz-1

By considering the linear demand curve explain how price changes affect the
consumer surplus.
(The answer will be given at the end of this lesson.)
Producer Surplus

 After explaining consumer surplus, let’s investigate producer surplus.

 Assume that you would like to buy a table and there are five producers in
the market: Ahmet, Mehmet, Ali, Kağan and Arda.
 You decide to take bids from these five producers and you will buy the
table from the producer who offers the lowest price.
 Each producer is willing to sell its product if the price he would receive
exceeds his cost.
 Here, the cost should be thought as the producer’s opportunity cost.
 This cost covers producer’s expenses in order to produce the table (wood,
polisher, nails etc.) and the value that the producer places on his time that
he spends to produce the table.
Producer Surplus
 When you take bids from the producers the price may be high at first
however, it quickly falls as the producers compete in order to sell their
tables.
 Let’s have a look at the costs of these producers.
 As it is seen from the table, when Producers Costs
Arda bids 700 TL or slightly less he will Ahmet 1000 TL
be the only producer remaining Mehmet 900
in the market. Ali 800
 Arda will be happy to sell the table Kağan 700
at this price. Because, his cost is 600 TL. Arda 600
 Ahmet, Mehmet, Ali and Kağan are unwilling to sell their tables at a price
less than 700 TL. Because at a price less than 700 TL these producers do not
cover their costs.
 At the end, the producer who offers the lowest price will be able to sell the
table.
Producer Surplus

 What benefit does Arda get by selling the table?

 Since Arda is willing to sell its product
at 600 TL but receives 700 TL we can say
that Arda obtains producer surplus of 100 TL.
Producers Costs
 Producer surplus is the amount a seller
Ahmet 1000 TL
gets minus the cost of production.
Mehmet 900
 Producer surplus measures the benefits
Ali 800
sellers/producers obtain by joining the
Kağan 700
market. Arda 600
 Producer Surplus
 Let’s find the supply schedule and draw the supply curve for our example.
 As it is celarly seen, when the price is less than 600 TL there would be no producer in the
market. Because this price does not cover the costs of any producers.
 When the price is between 600 TL and 700 TL
there would be one producer in the market: Arda Producers Costs
 When the price is between 700 TL and 800 TL Ahmet 1000 TL
there would be two producers in the market: Arda and Kağan Mehmet 900
 When the price is between 800 TL and 900 TL
Ali 800
there would be three producers in the market: Arda, Kağan
Kağan 700
and Ali.
Arda 600
 When the price is between 900 TL and 1000 TL
there would be four producers in the market: Arda, Kağan, Ali and Mehmet.
 Finally, when the price is higher than 1000 TL
there would be five producers in the market: Arda, Kağan, Ali, Mehmet and Ahmet.
 Producer Surplus
Price
Supply
a
Supply Schedule 1000
Price Quantity Supplied 900

Less than 600 TL 0 800

600 TL to 700 TL 1 700
700 TL to 800 TL 2 600
800 TL to 900 TL 3
900 TL to 1000 TL 4
1000 TL or more 5 0 1 2 3 4 5
Quantity
Measuring Producer Surplus by Using
the Supply Curve
 Producer surplus has a close relationship with supply curve.
 To understand this let’s consider our previous example.
 Similar to the consumer surplus and the demand curve, the height of the
supply curve indicates the costs of the producers.
 At any quantity, the price given by the supply curve shows the cost of the
marginal seller.
 Marginal seller is the seller who would leave the market first if the price were
any lower.
 For example, at a quantity of 3 the supply curve has a height of 800 TL. This
is the cost that Ali (marginal seller) incurs to produce the table.
 Since the supply curve reflects the sellers’ costs we can use it to measure
the producer surplus.
 Measuring Producer Surplus by Using the
Supply Curve
 Producer surplus equals the area below the price and above the supply curve.
 Let’s calculate the producer surplus by using Price
the supply curve of our example. Supply
 When the price is 700 TL or slightly less the quantity 1000
supplied is 1. 900
 Since the producer surplus equals the area below 800
the price and above the supply curve it equals 700
the area of green rectangle. 600
 So, the producer surplus is (700 – 600) x 1 = 100 x 1 = 100

0 1 2 3 4 5
Quantity
Measuring Producer Surplus by Using the
Supply Curve
 When the price is 800 TL or slightly less the
quantity supplied is 2. Price
Supply
 In this case, producer surplus equals the sum of
1000
the areas of green and purple rectangles.
900
 So, the producer surplus is
800
(800 – 600) x 1 = 200 x 1 = 200 (the area of
the green rectangular) 700

(800 – 700) x (2 – 1) = 100 x 1 = 100 (the area of 600

the purple rectangular)
 The producer surplus is 200 + 100 = 300
0 1 2 3 4 5
Quantity
Quick Quiz-2

By considering the linear supply curve explain how price changes affect the
producer surplus.
(The answer will be given at the end of this lesson.)
Market Efficiency

 To calculate market efficiency we need to find a measure for economic

well-being of a society at first.
 One measure of economic well-being of a society is the sum of consumer
surplus and producer surplus.
 The sum of consumer surplus and producer surplus is called total surplus.
 Remember that consumer surplus is the benefit that consumers get by
joining the market. Similarly, producer surplus is the benefit that producers
get by joining the market.
 So, total surplus is a good measure of economic well-being of a society.
Market Efficiency

 Let’s remember how we calculate the consumer and the producer surplus
 Consumer Surplus = Value to buyers – Amount paid by buyers
 Producer Surplus = Amount received by sellers – Cost to sellers
 Total Surplus = (Value to buyers – Amount paid by buyers) + (Amount
received by sellers – Cost to sellers)
 Since the amount paid by buyers equals the amount received by sellers
these two terms cancel each other. So, the total surplus is
 Total Surplus = (Value to buyers – Cost to sellers)
 If an allocation of resources maximizes total surplus it is said that the
allocation displays efficiency.
Market Efficiency

 If an allocation is not efficient then some of the gains from trade are not
being realized.
 For example, an allocation is inefficient if the good is not produced by the
sellers with lowest cost.
 In this situation, if production is moved from high-cost producer to low-cost
producer total cost to sellers will decrease and total surplus will increase.
 Likewise, an allocation is inefficient if the good is not consumed by the
buyers who value it most.
 In this situation, if consumption is moved from the buyer with low valuation
to the buyer with high valuation this will increase total surplus.
Market Equilibrium

 Now, we can investigate consumer and producer surplus when market

reaches equilibrium.
 Remember that consumer surplus equals the area above the price and
under the demand curve and the producer surplus is the area below the
price and above the supply curve.
 So, the total area between the supply and demand curves up to the point
of equilibrium shows the total surplus.
 Let’s see this graphically.
Market Equilibrium

 This graph shows consumer and producer Price

C
surplus when the market reaches equilibrium. B
Consumer
 Since the consumer surplus is the area above Surplus Supply

the equilibrium price and under the demand

F E
curve it equals the area of blue triangle. Equilibrium
price
 The producer surplus is the area below
the equilibrium price and above the supply Producer
D
curve it equals the area of red triangle. Surplus
A Demand

 So, the total surplus equals the sum of the Equilibrium Quantity
quantity
area of blue and red triangles.
 Market Equilibrium

 Now we can ask that is equilibrium allocation of resources efficient?

 In other words, does equilibrium allocation of resources maximize total surplus?
 As it is known, when a market reaches
Price
equilibrium the price determines which buyers and C
B
sellers join the market. Consumer
Surplus Supply
 At the equilibrium price, buyers who value the
good more than the price choose to buy the good. F E

(represented by the segment CE of the demand

curve).
 Similarly, at the equilibrium price, sellers whose cost Producer
D
Surplus
A Demand
are less than the price choose to produce and sell the good.
Equilibrium Quantity
(represented by the segment AE of the supply curve). quantity
Market Equilibrium

 According to these observations we can state the following outcomes

about markets:
 Free markets allocate the supply of the goods to the buyers who value them
most highly (measured by their willingness to pay.)
 Free markets allocate the demand for the goods to the sellers who can produce
them at the lowest cost.
 So, economic well-being cannot be increased by changing the allocation
of consumption among buyers or the allocation of production among
sellers.
 Free markets lead to an equilibrium which maximizes the sum of consumer
and producer surplus.
 Quick Quiz-1 (Answer)
 By considering the linear demand curve explain how price changes affect the
consumer surplus.
 In order to answer this question let’s assume that the price of the good is P1 at the
begining and it falls P2 after a while.
 This figure shows how consumer surplus changes
Price
when the price falls from P1 to P2.
A
 Remember consumer surplus is the area above
Initial Consumer Surplus
the equilibrium price and under the demand
curve. So, the initial consumer surplus equals B C Consumer Surplus
P1
to new
the area of ABC triangle. consumers
DD E F
 When the price falls from P1 to P2 consumer surplus P2 Additional Consumer
Surplus to Initial
equals the area of ADF. Consumers
 The increase in consumer surplus which stems from the Q1 Q2 Quantity

lower price is the area of BCDF

 Quick Quiz-1 (Answer)

 The increase in consumer surplus consists of two parts.

 First, consumers who were already buying Q1 of the good at the higher price P1 are in
a better position because they pay less.
Price
 The increase in consumer surplus of existing buyers
A
equals the area of the rectangle BCDE.
Initial Consumer Surplus
 Second, new buyers enter the market. Because they
are willing to buy the good at the lower price. P1
B C Consumer Surplus
to new
 The consumer surplus of new buyers equals the area of consumers
D E
P2
CEF. Additional Consumer F
Surplus to Initial
 Homework: Explain the change in consumer surplus Consumers
Q1 Q2 Quantity
when the price of the good increases.
 Quick Quiz-2 (Answer)

 By considering the linear supply curve explain how price changes affect the producer
surplus.
 In this case, let’s suppose the price increases from P1Price
to P2. Additional Producer
Surplus to Initial Producers
 Recall that producer surplus is the area below
P2 F
the equilibrium price and above the supply E D
Producer Surplus
curve. P1 C
B to New Producers

 When the price is P1 producer surplus equals the area

Initial Producer Surplus
of the triangle ABC. A

 When the price increases from P1 to P2 the producer Q1 Q2 Quantity

surplus is the area of AEF.

Quick Quiz-2 (Answer)

 The increase in producer surplus is composed of two parts.

 First, the producers who were already selling Q1 of good at a lower price P1 are in
a better position because they gain more for the goods they sell.
 The increase in producer surplus for the existing sellers equals the area of BCDE
(light blue rectangle).
 Second, some new sellers enter the market because they are willing to sell their
products at a higher price.
 The producer surplus of these new sellers is the area of CDF triangle.
 Homework: Explain the change in consumer surplus when the price of the good
decreases.
References

 Mankiw, N. Gregory (2018): Principles of Economics, Eighth Edition,

Cengage Learning, USA.
 [Link]