CONSUMERS,PRODUCERS,

&THEEFFICIENCYOFMARKETS
Chapter 7

Kanika Talwar
Economics Department
SGTB Khalsa College
Consumer Surplus

u Willingness to pay is the maximum amount that a buyer will pay for a good.

u Consumer surplus is a buyer’s willingness to pay minus the amount the buyer
actually pays.

u For example if a buyer has a willingness to pay of $20 for a good but the price
is only 15 , then his consumer surplus is 5.
Consumer Surplus & Demand Curve

u Suppose there are four buyers in the market for a good and the demand
schedule is given. We can plot the demand curve
u The graphs the demand curve that corresponds to this demand schedule.

u Note the relationship between the height of the demand curve and the buyers’ willingness to pay.

u At any quantity, the price given by the demand curve shows the willingness to pay of the marginal
buyer, the buyer who would leave the market first if the price were any higher.

u At a quantity of 4 albums, for instance, the demand curve has a height of $50, the price that Ringo
(the marginal buyer) is willing to pay for an album.

u At a quantity of 3 albums, the demand curve has a height of $70, the price that George (who is now
the marginal buyer) is willing to pay.

u Because the demand curve reflects buyers’ willingness to pay, we can also use it to measure
consumer surplus.
u The area above the price and below the
demand curve equals $20. This is amount the
consumer surplus of John if the price were 80.

u Similarly if the price was 70 both John and

Paul would have got a consumer surplus.

u This would again be corresponding to the area

above the price and below the demand curve.

u John’s CS at price $70 would be $30 and Paul’s

$10.

u The total would be $40.

u The area below the demand curve and above

the price measures the consumer surplus in a
market.
Lower Price Raises Consumer
Surplus
u A lower price raises the area under the
demand curve and thus raises consumer
surplus.

u In panel (a), the price is P1, the quantity

demanded is Q1, and consumer surplus
equals the area of the triangle ABC.

u When the price falls from P1 to P2, as in

panel (b), the quantity demanded rises
from Q1 to Q2, and the consumer surplus
rises to the area of the triangle ADF. The
increase in consumer surplus (area BCFD)
occurs in part because existing consumers
now pay less (area BCED) and in part
because new consumers enter the market
at the lower price (area CEF).
Producer Surplus

u Willingness to sell is the minimum amount that a seller willing to sell a good for pay. It is usually
reflected as the cost to the buyer.

u Cost is the value of everything that a seller gives up to produce a good. Here the cost is the
opportunity cost which includes the out of pocket costs and intuitive costs.

u Producer surplus the amount a seller is paid for a good minus the seller’s cost.

u Producer surplus measures the benefit to sellers of participating in a market.

Example

u Suppose you want to get your house painted and there are four bidders who are willing to do so but
have different costs.
Supply Curve and Producer Surplus

u The supply schedule corresponds to the costs.

u If the price is below $500, none of the four painters is willing

to do the job, so the quantity supplied is zero.

u If the price is between $500 and $600, only Grandma is willing

to do the job, so the quantity supplied is 1.
u If the price is between $600 and $800, Grandma and Georgia
are willing to do the job, so the quantity supplied is 2, and so
on.

u Thus, the supply schedule is derived from the costs of the four
painters.

u At any quantity, the price given by the supply curve shows the
cost of the marginal seller, the seller who would leave the
market first if the price were any lower.
u xys
u The area below the price an above the supply curve measures the producer surplus.

u In panel (b) the surplus increases as price rises for P1 to P2. . The quantity supplied increases from Q1 to Q2
The Benevolent Social Planner

u The benevolent social planner is an all-knowing, all-powerful, well-intentioned dictator.

u The planner wants to maximize the economic well-being of everyone in society.

u The planner must first decide how to measure the economic well-being of a society. One
possible measure is the sum of consumer and producer surplus, which we call Total Surplus.

Total Surplus = Consumer Surplus + Producer Surplus

= Value to buyers - Amount Paid by the buyers +
Amount Received by Sellers – Cost to Sellers
= Value to buyers - Cost to Sellers
u Total surplus in a market is the total value to buyers of the goods, as measured by their
willingness to pay, minus the total cost to sellers of providing those goods.

u If an allocation of resources maximizes total surplus, we say that the allocation exhibits
efficiency.

u If an allocation is not efficient, then some of the gains from trade among buyers and sellers are
not being realized.

u For example, an allocation is inefficient if a good is not being produced by the sellers with lowest
cost. In this case, moving production from a high-cost producer to a low-cost producer will lower
the total cost to sellers and raise total surplus.

u Similarly, an allocation is inefficient if a good is not being consumed by the buyers who value it
most highly. In this case, moving consumption of the good from a buyer with a low valuation to a
buyer with a high valuation will raise total surplus.
 MARKET EQUILIBRIUM & EFFICIENCY
u Under market is in equilibrium, the price
determines which buyers and sellers participate in
the market.

u Those buyers who value the good more than the

price (represented by the segment AE on the
demand curve) choose to buy the good and those
buyers who value it less than the price
(represented by the segment EB) do not.

u Similarly, those sellers whose costs are less than

the price (represented by the segment CE on the
supply curve) choose to produce and sell the good
and those sellers whose costs are greater than the
price (represented by the segment ED) do not.
u At quantities less than the equilibrium
quantity, the value to buyers exceeds the
cost to sellers.

u At quantities greater than the equilibrium

quantity, the cost to sellers exceeds the
value to buyers.
P
u Therefore, the market equilibrium
maximizes the sum of producer and
consumer surplus.

u Free markets produce the quantity of goods

that maximizes the sum of consumer and
producer surplus.