Consumer Surplus Producer Surplus

Consumer Surplus Producer Surplus - Transcript

Session 6

Consumer Surplus Producer Surplus Market Efficiency Theory of Consumer Choice

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Market Equilibrium Revisited
Does the equilibrium price and quantity result in the maximum total welfare of buyer and seller

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PE D
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Welfare Economics Welfare Economics
Equilibrium in the market results in maximum benefits and therefore total welfare for both the buyer and the seller Welfare Economics from the Buyer Side and the Seller Side
Consumer Surplus Producer Surplus
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Welfare Economics Consumer Surplus
Market Demand Curve It depicts various quantities that buyers would want to purchase at different prices What determines how much a consumer would be willing to pay the maximum price for a good or service
Answer Utility
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The expected benefits received or
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Consumer Surplus arises
when the willingness to pay is higher than what a consumer actually pays for a good or a service The maximum amount a consumer will be willing to pay for a good service depends on the expected utility benefits derived from it Willingness to Pay
The maximum price that a buyer is willing and able to pay for a good service Measures how much the buyer values the good or service
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Consumer Surplus Verbal Definition Definition
P

The amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it

D
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Q

Consumer Surplus Graphical
Pmax S

D
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Consumer Surplus Graphical
Pmax S

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Consumer Surplus Graphical
Pmax S

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Consumer Surplus Graphical
Pmax S Consumer Surplus

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Consumer Surplus and Market Price
The area below the demand curve and above the market price measures the consumer surplus in a market Hence
A lower market price will increase consumer surplus A higher market price will reduce consumer surplus
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Consumer Surplus Example
Maximum Price 11 Market Price 6 Quantity Purchased 6 units Assume Price drops 1 additional unit sold Consumer Surplus 15

for

every

51 36 15 15 11 10 9 8 7 6 6 x 6 15
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11 10 9 8 7
Market Price Price

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Quantity Purchased

5

6

13

P

11 10 9 8 7 6

Total Consumer Consumer Benefits

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5

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P

11 10 9 8 7 6

Consumer s Expense

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15

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11 10 9 8 7 6

Consumer Benefit Consumer Expense

CONSUMER SURPLUS

51 36

15
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Producer Surplus
Market Supply Revisited It depicts the various quantities that suppliers would be willing to sell at different prices

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Producer Surplus Verbal Definition
P

The amount a seller actually receives for ll selling certain amount of good services minus the total cost of producing such amount Producer surplus measures the benefit to sellers over and above the cost
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Producer Surplus Graphical
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Producer Surplus Graphical
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Producer Surplus Graphical
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Producer Surplus D

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Producer Surplus Example
Minimum Cost Price 1 Market Price 6 6 Quantity Sold 6 units Assume Cost increases additional unit produced Producer Surplus 15

1

for

every

36 21 15 21 15 6 x 6 1 2 3 4 5 6 15
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P

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6 5 4 3 2 1
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Total Producer Benefits

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6 5 4 3 2 1
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P

Producer Surplus 15 Surplus 15

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6 5 4 3 2 1
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Producer Costs

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Market Efficiency
Under the assumptions of perfect competition and no externalities the economic well being of a society is measured as the sum of consumer surplus and producer surplus Market Efficiency is attained when total surplus is maximized a point where resource allocation is efficient
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Market Efficiency
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Market Efficiency
Consumer Surplus PE Producer Surplus
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Market Efficiency Three Observations Free markets allocate the supply of goods to the buyers who value them most highly Free markets allocate the demand for goods to the sellers who can produce them at least cost Free markets produce the quantity of ee goods that maximizes the sum of consumer and producer surplus
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Market Efficiency Invisible Hand
In a free market system many buyers and sellers are interested in their own wellbeing self interest As market participants are motivated by self interest a process of coordination and communication takes place so that buyers and sellers are directed to the most efficient outcome As if by an Invisible Hand the free market system reaches efficiency
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Market Efficiency Imperfect Market Market Efficiency Imperfect Market
If a market system is not one of perfect competition control over prices leads to Market Power The ability by one buyer or seller to y control market price Market Power causes markets to be inefficient
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Overview Theory of Consumer Choice
Cardinal Approach Law of Diminishing Marginal Utility Law of Equi Marginal Utility and Ordinal Approach Indifference Curve Analysis Revealed Preference Theory etc Indifference Curve Analysis Budget constraint Indifference curve Consumer s optimal choice Deriving the demand curve
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Budget Constraint What Consumers Can Afford
The budget constraint depicts the consumption possibilities available to the consumer People consume less than they desire because their spending is constrained or limited by their income
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Budget Constraint
Shows what combination of goods the consumer can afford given his income and the prices of the two goods

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Pepsi
2

Budget Constraint Budget Constraint

Pizza
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Budget Constraint
Pepsi
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500

Pizza
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Pepsi
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Budget Constraint
B

500

A Pizza
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Budget Constraint
Pepsi
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500

B

250

C

A Pizza
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Budget Constraint
Pepsi
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500

B

Any point on the constraint line equals 1 000 the income available to spend on the two products C

250

A Pizza
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Budget Constraint Budget Constraint
The slope of the budget constraint measures the rate at which the consumer can trade one good for the other The slope equals the ratio of the prices of two goods

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Preferences What the Consumer Wants
A consumer s preference choice between different bundles of goods and services may be illustrated with indifference curves An indifference curve depicts bundles of goods that leave the consumer equally welloff It shows the combinations of goods that give the consumer a constant level of utility
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Indifference Curves
Pepsi

I2 I1 Pizza
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Indifference Curves
Pepsi

C

B A
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I2 I1 Pizza
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Indifference Curves Indifference Curves
The consumer is indifferent among combinations A B and C because they are all on the same curve The slope at any point on an indifference curve equals the rate at which the consumer is willing to substitute one good for the other
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Indifference Curves
Pepsi

C

B A
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D I1

I2 Pizza
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Indifference Curves
Pepsi

C

Slope between points A and B Tradeoff between the two bundles
B A D I1 Pizza
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I2

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Marginal Rate of Substitution Marginal Rate of Substitution
The slope of indifference curve is known as marginal rate of substitution


The rate at which consumers are willing to trade one good for another The amount that the consumer must receive as compensation in order to give up something else that he she desires
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Preferences What the Consumer Wants
The consumer prefers indifference curves to others


some



Because he prefers more consumption to less i e higher indifference curves are preferred to lower ones Points on a hi her indifference curve are high preferred to any point on lower curves
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Indifference Curves
Pepsi

C D B A
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I2 I1 Pizza
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Properties of Indifference Curves
Higher indifference curves are preferred to lower ones Indifference curves are negatively sloped Indifference curves do not cross

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Higher indifference curves are preferred to lower ones
Indifference curves further from the origin represent higher levels of well being or utility Consumers prefer to be on an indifference curve that is as far from the origin as possible
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Indifference curves are cu negatively sloped
The fact that the consumer is willing to give up less and less amount of good y for each additional unit of good x which results in the negatively sloped indifference curve The negative slope is due to diminishing marginal rate of substitution
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Indifference curves do not cross
In order for preference rankings to be consistent indifference curves cannot intersect or cross If indifference curves were to cross the assumption that more is preferred to less would be violated
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Extreme Indifference Curves
Perfect Substitutes The indifference curves have a constant marginal rate of substitution and the curves are straight lines

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Tea
6

Perfect Substitutes
4

2

I1
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I3
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Coffee
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Extreme Indifference Curves Extreme Indifference Curves
Perfect Substitutes The indifference curves have a constant marginal rate of substitution and the curves are straight lines Perfect Complements The indifference curves have lines that are at right angles to each other

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Perfect Complements
Left Shoes

I2 I1 Right 57 Shoes

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Optimization What the Consumer Chooses
Consumers would like to obtain the combination of goods on the highest possible indifference curve However the budget constraint may restrict or limit the consumer to a lower indifference curve Combining the indifference curve and budget constraint determines the optimum choice
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Consumer s Optimal Choice
Pepsi Consumer s indifference curves based on personal curves based on personal preferences

I3 I2 I1 Pizza
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Consumer s Optimal Choice
Pepsi Consumer s budget constraint

I3 I2 I1 Pizza
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Consumer s Optimal Choice
Pepsi Optimal Choice given personal personal preference and budget constraint and budget constraint I3 I2 I1
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QPepsi

QPizza S Prusty

Pizza
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Consumer s Optimal Choice
The point at which the indifference curve and the budget constraint touch i e its tangent is called the optimum The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the price ratio

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Mathematical Expression Mathematical Expression
Utility Function U U QX QY Marginal Utility
MUX U QX and MUY U QY

Second Derivatives Derivatives
MUX QX 0 and MUY QY 0

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Marginal Rate of Substitution Marginal Rate of Substitution
Rate at which one good can be substituted for another while holding utility constant Slope of an indifference curve
dQY dQX MUX MUY

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The Budget Line The Budget Line
Budget M PXQX PYQY Slope of the budget line of the budget line
dQY dQX PX PY

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Budget Lines Change in Price Budget Lines Change in Price
GF M 6 PX PY 1 6 1 GF PX 2 GF PX 0 67

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Budget Lines Change in Income Budget Lines Change in Income

GF M 6 PX PY 1 6 1 GF M 3 PX PY 1

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Consumer Equilibrium Consumer Equilibrium
Combination of goods that maximizes utility for a given set of prices and a given level of income Represented graphically by the point of tangency between an indifference curve and the budget line
MUX MUY PX PY MUX PX MUY PY
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Mathematical Derivation Mathematical Derivation
Maximize Utility U f QX QY Utilit f Q Subject to M PXQX PYQY Set up Lagrangian function
L f QX QY M PXQX PYQY

First order conditions imply
MUX PX MUY PY MU MU

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The image cannot be display ed Your computer may not hav e enough memory to open the image or the image may hav e been corrupted Restart y our computer and then open the file again If the red x still appears y ou may hav e to delete the image and then insert it again

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Deriving the Demand Curve
A consumer s demand curve is a summary of the optimal decisions that arise from his budget constraint and indifference curves Downward sloping demand curve is derived from the optimum points i e point of tangency between indifference curve and budget line by y changing the price of a commodity and keeping the price of another commodity unchanged This results in a demand curve stating the negative relationship between price and quantity demanded of a particular commodity
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Conclusion Conclusion
Indifference curve analysis describes how individuals make decisions It has many relevant and interesting applications If people behave as if they followed the model then the model will yield accurate and useful predictions and results
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