Chapter 4 Study Notes
I. Consumer and producer surplus
1. Consumer surplus
a. Definition: consumer surplus is the difference between what consumer is willing to
pay and the market price.
b. For example, buyer is willing to pay 20,000 for a car, the negotiated price is 17,200.
The consumer surplus is 20000-17200 =2800.
c. Consumer surplus is equal to the area above price, and below the demand curve.
2. Producer surplus
a. Definition: producer surplus is the difference between the market price and the
price at which the firms are willing to supply the product.
b. For example, the seller is willing to accept 15,000 for the car, and the negotiated
price is 17,200. The producer surplus is 17200 – 15000 = 2200.
c. Producer surplus is equal to the area below market price, and above the supply
curve.
3. Application: Calculate consumer and producer surplus given the market graph. Figure 2.
II. Using consumer and producer surplus: the gains from trade
1. Total surplus
a. Total surplus = consumer surplus + producer surplus
b. It’s a measure of the overall net benefit gained from a market transaction.
c. Markets are efficient when total surplus is the highest possible – at the market
equilibrium.
d. Deadweight loss is the reduction in total surplus that results from the inefficiency of
a market not in equilibrium.
2. Application: calculate CS, PS, and DWL when price deviates from market equilibrium.
a. When price exceeds equilibrium, Figure 3
b. When price is below equilibrium, Figure 4
III. Price ceiling and price floors
1. Laissez-faire: a government that is allowed to function without any government
intervention.
2. Price ceiling
a. Price ceiling is a maximum price established by the government for a product or
service.
b. Effective price ceiling is below the equilibrium price.
c. Price ceiling creates shortages and dead weight loss.
d. Misallocation of resources occurs when a good or service is not consumed by the
person who values it the most and typically results when a price ceiling creates an
artificial shortage in the market.
e. Price gouging laws creates shortages. Government should focus on providing
incentives to increase supply.
3. Price floor
a. Price floor is a minimum price established by the government for a product or
service.
b. An effective price floor is above market equilibrium price.
c. Price floor creates surpluses and dead weight loss.
d. Minimum wage creates surpluses in low skilled labor market. The government
should focus on provide education and job-training incentives to workers.
e. Agricultural price support often leads to government buying the surplus food. The
food surplus results in allocation issues, and higher food prices reduces the potential
gains from trade.
IV. Market failures
1. Market failure occurs when a free market does not lead to a socially desirable outcome.
2. Causes of market failure
a. Lack of competition: can lead to higher prices to consumers.
b. Asymmetric information: occurs when one party to a transaction has significantly
better information than another party.
i. The seller of a used car knows better the true condition of the car than the
buyer.
ii. People seeking a loan knows better the chance of default than the lender.
c. Existence of externality
i. External benefit occurs when an action has a positive effect on a third party
(planting trees, education…)
ii. External cost occurs when an action adds a cost to a third party (pollution,
having loud parties…)
d. Existence of public good
i. Public goods are nonrival and nonexclusive.
ii. Nonrival: one person’s consumption does not diminish another person’s benefit.
iii. Nonexclusive: once a public good is provided, no one can be excluded from
consuming it.
3. Three key societal issues
a. Climate change is a market failure because it exhibits characteristics of public goods.
Actions taken to combat climate change are costly, but the benefits are enjoyed by
everyone.
b. Public health care involves external benefit (higher worker productivity and
happiness) as well as external costs (high costs which can impede growth).
c. Education offers external benefits by making society more productive. But increasing
educational opportunities requires subsidies that are paid for by taxes.