Chapter

 5  
 
! Consumer  surplus  and  producer  surplus  
! Efficient  market  outcome  
o Taxation  and  efficiency  
o Market  regulation  and  efficiency  
! Market  failure  
o Negative  externalities  
o Positive  externalities  
 
 
 
! Consumer  surplus  (CS)  and  producer  surplus  (PS)  
 
-­‐ Consumer  surplus  (CS)  is  related  to  the  demand  side  of  the  market.    
-­‐ CS  is  the  difference  between  the  consumer’s  willingness  to  pay  and  what  is  
actually  paid.  
o In  other  words,  the  difference  between  the  individual’s  valuation  
(demand  curve)  and  the  market  price  
-­‐ The  demand  curve  also  shows  the  benefit  the  consumer  gets  from  each  unit  
of  product.  For  this  reason,  demand  is  also  called  marginal  benefit  (MB).  
 
 
 
 
 
  CS  =  Area  of  the  blue  triangle  

  1  
  
 
-­‐ Producer  surplus  (PS)  is  related  to  the  supply  side  of  the  market.  
-­‐ PS  is  the  difference  between  the  price  the  producer  receives  and  the  price  the  
producer  would  be  willingness  to  accept  
o In  other  words,  the  difference  between  the  market  price  received  by  
the  producer  and  the  reservation  price  (supply  curve).  
-­‐ Supply  curve  also  reflects  the  cost  associated  with  every  additional  unit  of  
production.  For  this  reason,  supply  is  also  called  marginal  cost  (MC).  
 

 
 
 
 
 
! Efficient  market  outcome  
 
-­‐ The  market  maximises  the  sum  of  producer  and  consumer  surplus.  This  
particular  quantity  of  output  is  therefore  efficient.  
-­‐ At  this  point  marginal  benefit  (MB  or  demand)  is  equal  to  marginal  cost  (MC  
or  supply).  
 
 
 
-­‐ Efficient  market  
equilibrium:  
MB  (or  D)  =  MC  (or  S)  "  Qe,  Pe  
 
-­‐    Total  surplus  (TS)  =  CS  +  PS  
 
 
 
 
 
 

  2  
  
o Taxation  and  efficiency  
 
Assume  that  the  government  taxes  the  supply  side:  
-­‐  Supply  shifts  to  the  left.  
 

 
 
-­‐ As  a  result,  the  price  that  consumers  pay  increases  (from  Pe  to  Pc)  and  the  
price  that  producers  receive  decreases  (from  Pe  to  Pp).  The  difference  (Pc  –  
Pp)  is  the  tax  amount  that  is  received  by  government.  
 
o Since  the  price  for  both  consumers  and  producers  changes,  both  
consumer  surplus  and  producer  surplus  would  change.  
 
 
Dead  
Consumer   Producer   Total  
Price  and   Government   weight  
Taxation   surplus   surplus   Surplus  
Quantity   revenue   loss  
(CS)   (PS)   (TS)  
(DWL)  
a+b+g+e+c
Before  tax   Pe,  Qm   a+b+g+e   c+f+d   0   0  
+f+d  
a+d+b+g+
After  tax   Pc,  Qt   a   d   b+g+c  
c   e+f  
Change  in  surplus   _   -­‐(b+g+e)   -­‐(c+f)   b+g+c   -­‐(e+f)  
 
-­‐ Taxation  decreases  the  quantity  and  raises  the  price.  
-­‐ Deadweight  loss  (DWL)  occurs  because  taxation  results  in  lower  equilibrium  
level  of  output.    
 
-­‐ Deadweight  loss  (DWL)  implies  an  efficiency  loss.  
 

  3  
 -­‐ The  magnitude  of  the  DWL  depends  on  the  elasticities  of  demand  and  supply.  
More  elastic  demand  and  supply  imply  larger  quantity  adjustments  and  
therefore  larger  DWL.  
 
-­‐ Practice:  Compare  the  consumer’s  share  in  deadweight  loss  and  the  
producer’s  share  in  deadweight  loss,  when  demand  is  less  elastic  than  
supply.  
 
 
 
o Market  regulation  and  efficiency  
 
 
Price  ceiling:  

 
 
 
Consumer   Producer  
Price  &   Total  Surplus   Deadweight  
Price  ceiling   surplus   surplus  
Quantity   (TS)   loss  (DWL)  
(CS)   (PS)  
Before  price  control   Pe,  Qe   a+c   b+d+e   a+b+c+d+e   0  
After  price  control   Pc,  Qc   a+b   e   a+b+e  
c+d  
Change  in  surplus   _   b-­‐c   -­‐(b+d)   -­‐(c+d)  
 
 
 
 
 
 
 
 

  4  
Price  floor:  
 
 

 
 
Consumer   Producer  
Price  &   Total  Surplus   Deadweight  
Price  floor   surplus   surplus  
Quantity   (TS)   loss  (DWL)  
(CS)   (PS)  
Before  price  control   Pe,  Qe   a+b+d   c+e   a+b+d+c+e   0  
After  price  control   Pf,  Qf   a   b+c   a+b+c  
d+e  
Change  in  surplus   _   -­‐(b+d)   b-­‐e   -­‐(d+e)  
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

  5  
Quota:  
 
 

 
 
 
Consumer   Producer  
Price  &   Total  Surplus   Deadweight  
Quota   surplus   surplus  
Quantity   (TS)   loss  (DWL)  
(CS)   (PS)  
Before  quota   Pe,  Qe   a+b+d   c+e   a+b+d+c+e   0  
After  quota   Pq,  Qq   a   b+c   a+b+c  
d+e  
Change  in  surplus   _   -­‐(b+d)   b-­‐e   -­‐(d+e)  
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

  6  
 ! Market  failure  
-­‐ Market  failure  is  when  the  market  does  not  come  up  with  an  efficient  
solution.  
-­‐ In  this  case,  government  intervention  can  correct  the  market  solution.  
-­‐ One  example  of  market  failure  is  an  externality.  
-­‐ An  externality  refers  to  the  cost/benefit  affecting  parties  other  than  those  
involved  in  the  market  activity.  
-­‐ There  are  two  types  of  externality:  a  negative  externality  and  a  positive  
externality.  
 
 
o Negative  externalities:  refer  to  costs  affecting  a  third  (outside)  party.  
Example:  pollution  
 
-­‐ In  the  market  for  cars,  pollution  adversely  affects  the  health  of  the  population  
and  the  environment,  and  not  only  car  producers  and  buyers.  
-­‐ The  polluting  firm  faces  only  the  production  cost  (or  private  cost)  of  the  car.  
-­‐ Society  faces  the  social  costs,  which  include  the  private  cost  and  the  negative  
effect  on  health  and  the  environment.    
-­‐ Social  cost  (Ss)  >  Private  cost  (SM)  "    
-­‐ Therefore,  graphically,  total  supply  (marginal  social  cost)  is  above  the  market  
supply  (marginal  private  cost)  
 
 

  7  
 Negative  externality   CS   PS   Cost  of  pollution   Net  effect  
Market  solution   a  +  b  +  e  +  f   c  +  d  +  g   -­‐  (d  +  e  +  f  +  g  +  h  )   -­‐h  
 
 
-­‐ Given  two  supply  curves,  there  are  two  optimal  outcomes:    
 
1. Social  optimum:    Ss  =  D  "Qs    
 
2. Private  optimum.    SM  =  D  "    Qm  
 
#  The  firm  overproduces  from  a  social  viewpoint  because  it  does  not  
take  into  account  the  negative  side  effects.    
Excessive  production  (Qs-­‐Qm)  is  not  efficient.  Beyond  Qs,  the  marginal  
social  cost  of  output  is  greater  than  the  marginal  benefit  of  it  (MCs  >  MB).  
 
 
How  could  we  decrease  output  to  the  socially  optimal  level  of  production?  
 
-­‐ Taxation  that  increases  the  price  and  reduces  output  is  a  solution  to  negative  
externalities.  
-­‐ Tax  the  output  such  that  the  after-­‐tax  market  supply  intersects  D  at  the  
socially  optimum  quantity  (Qs).  
-­‐ The  net  gain  from  taxation  is  area  h  on  the  graph,  which  is  removing  the  cost  
of  pollution  from  the  third  party.  
 
 
 
 
o Positive  externalities:  refer  to  the  benefits  affecting  a  third  (outside)  
party.  Example:  vaccination,  research  and  development  (R&D).  
 
-­‐ Positive  externalities  enable  the  third  party  to  get  a  type  of  “free  ride”  on  the  
efforts  of  others.  
-­‐ The  private  benefit  received  by  the  consumer  is  different  from  the  benefit  
received  by  society.    
-­‐ For  example:  vaccination  not  only  benefits  the  patient  but  the  entire  society.  
o The  patient  receiving  the  shot  considers  just  the  private  benefit.  
o However,  society  receives  a  social  benefit,  therefore,  social  demand  
(MBs)  includes  the  private  benefit  as  well  as  the  positive  effect  on  
others.  
o Society’s  benefit  (Ds)  >  Private  benefit  (Dp)  
 
-­‐ Therefore,  graphically,  the  marginal  benefit  to  society  (Df  or  MBs)  is  above  
the  marginal  private  benefit  (Dp  or  MBp)    

  8  
 -­‐ Given  the  two  demand  curves,  there  are  two  optimal  outcomes:  
o Social  optimum:  Df  =  S  "  Qs  
o Private  optimum:  Dp  =  S  "  Qm  
 
#  The  market  under-­‐produces  from  a  social  viewpoint  because  it  does  
not  take  into  account  the  positive  side  effect  on  society.  The  market  
production  level  is  not  efficient,  because  marginal  social  benefit  (MBs)  is  
greater  than  the  marginal  cost  of  it  (MBs  >  MC)  at  any  quantity  below  Qs.  
 
 

 
 
 
 
How  could  we  increase  output  to  the  socially  optimal  level  of  production?  
 
-­‐ Subsidising  suppliers,  so  that  price  decreases  and  increases  output,  is  a  
solution  to  positive  externalities.  
-­‐ Supply  increases  (shifts  to  the  right)  as  a  result  of  subsidisation  so  that  
output  increases  to  Qs.  
-­‐ Giving  an  income  tax  credit  to  buyers  is  an  alternative  to  increasing  output.  
In  this  case,  private  demand  shifts  to  the  right  resulting  in  a  higher  socially  
superior  quantity.  

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