The Study of Economics

The Study of Economics

THIRD EDITION > > ECONOMICS and MICROECONOMICS Paul Krugman | Robin Wells Chapter 4 Consumer and Producer Surplus 2011 Worth Publishers WHAT YOU WILL LEARN IN THIS CHAPTER

What consumer surplus is and its relationship to the demand curve What producer surplus is and its relationship to the supply curve What total surplus is and how it can be used both to measure the gains from trade and to illustrate why markets work so well Why property rights and prices as economic signals are critical to smooth functioning of a market Why markets typically lead to efficient outcomes despite the fact that they sometimes fail Consumer Surplus and the Demand Curve A consumers willingness to pay for a good is the maximum price at which he or she would buy that good.

Individual consumer surplus is the net gain to an individual buyer from the purchase of a good. It is equal to the difference between the buyers willingness to pay and the price paid. The Demand Curve for Used Textbooks Price of book $59 Aleisha Potential buyers Brad 45

Claudia 35 Darren 25 Edwina 10 D 0 1 2

3 4 5 Quantity of books Willingne ss to pay Aleisha Brad $59 Claudia 35

Darren Edwina 25 45 10 A consumers willingness to pay for a good is the maximum price at which he or she would buy that good. Willingness to Pay and Consumer Surplus Total consumer surplus is the sum of the individual consumer surpluses of all the buyers of a good. The term consumer surplus is often used to refer to both

individual and total consumer surplus. Consumer Surplus in the Used Textbook Market Price of book $59 Aleishas consumer surplus: $59 $39 = $29 Aleisha 45 Brads consumer surplus: $45 $30 = $15 Brad

35 Claudias consumer surplus: $35 $30 = $5 Claudia 30 Price = $30 25 Darren 10 The total consumer surplus is given by the entire shaded area

the sum of the individual consumer surpluses of Aleisha, Brad, and Claudia equal to $29 + $15 + $5 = $49. Edwina D 0 1 2 3 4

5 Quantity of books Consumer Surplus in the Used Textbook Market Consumer Surplus The total consumer surplus generated by purchases of a good at a given price is equal to the area below the demand curve but above that price. Price of iPad Consum er surplus

Price = $500 $500 D 0 1 million Quantity of iPads How Changing Prices Affect Consumer Surplus A fall in the price of a good increases consumer surplus through two channels: 1. a gain to consumers who would have bought at the original price 2. a gain to consumers who are persuaded to buy by the

lower price Consumer Surplus and a Fall in the Price of Used Textbooks Price of book $59 Aleisha 45 Brad Increase in Aleishas consumer surplus Increase in Brads

consumer surplus Claudia 35 30 Increase in Claudes consumer surplus Original price = $30 Darren 25 New price = $20 20

10 Edwina Darrens consumer surplus D 0 1 2 3 4

5 Quantity of books A Fall in the Market Price Increases Consumer Surplus Price of iPad Increase in consumer surplus to original buyers $2,000 Consumer surplus gained by new buyers 500 D

0 200,000 1 million Quantity of iPads FOR INQUIRING MINDS A Matter of Life and Death Each year, about 4,000 people in the United States die while waiting for a kidney transplant. According to the current United Network for Organ Sharing (UNOS) guidelines, a donated kidney goes to the person who has waited the longest regardless of their age. FOR INQUIRING MINDS A Matter of Life and Death The UNOS is now devising a new set of guidelines where

kidneys would be allocated on the basis of who will receive the greatest net benefit, where net benefit is measured as the increase in lifespan from the transplant. This would increase the recipients extra years by 11,000. The net benefit concept is like consumer surplus: the individual consumer surplus generated from getting a new kidney. ECONOMICS IN ACTION When Money Isnt Enough The key insight we get from the concept of consumer surplus is that purchases yield a net benefit to the consumer. The consumer typically pays a price less than his or her willingness to pay.

Most of the time we dont think about the value associated with the right to buy a good. ECONOMICS IN ACTION When Money Isnt Enough During World War II, governments in many countries created a system of rationing goods where coupons gave individuals the right to buy goods at the governmentregulated price. As a result, illegal markets in meat stamps and gas coupons emerged. Also, criminals began stealing and counterfeiting coupons.

People who bought ration coupons on the illegal market were paying for the right to get some consumer surplus. Producer Surplus and the Supply Curve A potential sellers cost is the lowest price at which he or she is willing to sell a good. Individual producer surplus is the net gain to a seller from selling a good. It is equal to the difference between the price received and the sellers cost. Total producer surplus in a market is the sum of the individual producer surpluses of all the sellers of a good. The Supply Curve for Used Textbooks Price of book Potential sellers

S $45 Engelbert 25 Carlos 15 5 0 Betty Andrew 1

2 3 4 5 Donna Quantity of books $5 15 Betty 25 35

Andrew 45 Carlos Donna 35 Engelbert Cost Producer Surplus in the Used Textbook Market Price of book S

$45 Engelbert 35 Donna Price = $30 Carloss producer surplus Bettys producer Andrews surplus producer surplus 30

25 Carlos Betty 15 5 Andrew 0 1 2 3 4

5 Quantity of books Producer Surplus Price of wheat (per bushel) S $5 The total producer surplus from sales of a good at a given price is the area above the supply curve but below that price.

Price = $5 Producer surplus 0 1 million Quantity of wheat (bushels) Changes in Producer Surplus When the price of a good rises, producer surplus increases through two channels: 1. the gains of those who would have supplied the good even at the original, lower price 2. the gains of those who are induced to supply the good by the higher price A Rise in the Price Increases Producer Surplus Price of wheat (per

bushel) Increase in producer surplus to original sellers Producer surplus gained by new sellers $7 New price = $7 Original price = $5 5 0 S

1 million 1.5 million Quantity of wheat (bushels) ECONOMICS IN ACTION High Times Down on the Farm The government encouraged the use of gasoline that contains a percentage of ethanol in order to fight air pollution and to reduce U.S. dependence on foreign oil. The average value of farmland in Iowa hit a record high in 2010.

ECONOMICS IN ACTION High Times Down on the Farm One result of the shift to ethanol fuel has been a rise in the demand for corn, leading to a surge in corn prices. In 2010, the price of corn jumped by 52%. A person who buys a farm in Iowa buys the producer surplus that farm generates. Higher prices for corn, which raised the producer surplus of Iowa farmers, made Iowa farmland more valuable. ECONOMICS IN ACTION Putting It Together: Total Surplus The total surplus generated in a market is the total net gain

to consumers and producers from trading in the market. It is the sum of the producer and the consumer surplus. The concepts of consumer surplus and producer surplus can help us understand why markets are an effective way to organize economic activity. Total Surplus Price of book S Equilibrium price Consumer surplus $30 E

Producer surplus D 0 1,000 Equilibrium quantity Quantity of books Consumer Surplus, Producer Surplus, and the Gains from Trade The previous graph shows that both consumers and producers are better off because there is a market in this good; i.e., there are gains from trade. These gains from trade are the reason everyone is better off participating in a market economy than they would be if each individual tried to be self-sufficient. But are we as well off as we could be? This brings us to the

question of the efficiency of markets. The Efficiency of Markets: A Preliminary View Claim: The maximum possible total surplus is achieved at market equilibrium. The market equilibrium allocates the consumption of the good among potential consumers and sales of the good among potential sellers in a way that achieves the highest possible gain to society. By comparing the total surplus generated by the consumption and production choices in the market equilibrium to the surplus generated by a different set of production and consumption choices, we can show that any change from the market equilibrium reduces total surplus. Three ways in which you might try to increase the total surplus 1. Reallocate consumption among consumerstake the good away from buyers who would have purchased the good in the market equilibrium, and give it to potential consumers

who wouldnt have bought it in equilibrium 2. Reallocate sales among sellerstake sales away from sellers who would have sold the good in the market equilibrium, and instead compel potential sellers who would not have sold the good in equilibrium to sell it 3. Change the quantity tradedcompel consumers and producers to transact either more or less than the equilibrium quantity Reallocating Consumption Lowers Consumer Surplus Price of book Loss in consumer surplus if the book is taken from Ana and given to Bob S A

$35 30 E B 25 D 0 1,000 Quantity of books Reallocating Sales Lowers Producer Surplus Price of book

S Y $35 E 30 25 X Loss in producer surplus if Yvonne is made to sell the book instead of Xavier D 0

1,000 Quantity of books Changing the Quantity Lowers Total Surplus Price of book Loss in total surplus if the transaction between Ana and Xavier is prevented $35 A 25 Y Loss in total surplus if the

transaction between Yvonne and Bob is forced E 30 S X B D 0 1,000 Quantity of books

ECONOMICS IN ACTION eBay and Efficiency Garage sales are an old American tradition: they are a way for people to sell items they dont want to others who have some use for them, to benefit both parties. However, many potential beneficial trades are missed because sellers and buyers may not be in position to meet one another because factors such as distance. ECONOMICS IN ACTION eBay and Efficiency

eBay provides a way for would-be buyers and would-be sellers of unique or used items to find one another even if they dont live in the same neighborhood or city. The potential gains from trade were evidently large: in 2010, eBay reported $53.5 billion in goods were bought and sold on its websites. ECONOMICS IN ACTION Take the Keys, Please A Boston couple used the online matching website RelayRides to rent out their car that had been sitting around largely unused, earning enough to pay for its upkeep and insurance.

The founder of RelayRides, Shelby Clark, reports that the average car renter on his website earns $250 per month. RelayRides and online matching companies like it are becoming more popular by helping individuals generate a little bit more surplus from their possessions. ECONOMICS IN ACTION Market Equilibrium Maximizes Total Surplus 1. Market equilibrium allocates consumption of the good to the potential buyers who value it the most, as indicated by the fact that they have the highest willingness to pay. 2. It allocates sales to the potential sellers who most value the right to sell the good, as indicated by the fact that they have

the lowest cost. Market Equilibrium Maximizes Total Surplus 3. It ensures that every consumer who makes a purchase values the good more than every seller who makes a sale, so that all transactions are mutually beneficial. 4. It ensures that every potential buyer who doesnt make a purchase values the good less than every potential seller who doesnt make a sale, so that no mutually beneficial transactions are missed. Market Equilibrium Maximizes Total Surplus As a result of these four functions, any way of allocating the good other than the market equilibrium outcome lowers total surplus. Three Caveats First, although a market may be efficient, it isnt necessarily fair. In fact, fairness, or equity, is often in conflict with

efficiency. Because society cares about equity, government intervention in a market that reduces efficiency while increasing equity can be justified. The second caveat is that markets sometimes fail. Under some well-defined conditions, markets can fail to deliver efficiency. When this occurs, markets no longer maximize total surplus. Three Caveats Third, even when the market equilibrium maximizes total surplus, this does not mean that it results in the best outcome for every individual consumer and producer. For instance, a price floor that kept the price up would benefit some sellers. But in the market equilibrium there is no way to make some people better off without making others worse off and thats the definition of efficiency. Why Markets Typically Work So Well

Economists have written volumes about why markets are an effective way to organize an economy. In the end, wellfunctioning markets owe their effectiveness to two powerful features: property rights and the role of prices as economic signals. Property rights are the rights of owners of valuable items, whether resources or goods, to dispose of those items as they choose. An economic signal is any piece of information that helps people make better economic decisions. A Few Words of Caution A market or an economy is inefficient if there are missed opportunities: some people could be made better off without making other people worse off.

The three principal sources of market failure are: 1. attempts to capture more resources that produce inefficiencies, 2. side effects from certain transactions, and 3. problems in the nature of the goods themselves. ECONOMICS IN ACTION A Great Leap Backward Economies in which a central planner, rather than markets, makes consumption and production decisions are known as planned economies. Examples: Russia and many Eastern European countries Planned economies are notorious for their inefficiency, and what is probably the most compelling example is the socalled Great Leap Forward which was instituted in China in

the late 1950s by Mao Zedong. ECONOMICS IN ACTION A Great Leap Backward Its intention was to speed up the countrys industrialization by shifting from urban to rural manufacturing: farming villages were supposed to start producing heavy industrial goods such as steel. The plan backfired as food production fell and at the same time, industrial output declined because of inexperienced rural producers.

The results were catastrophic as the following famine reduced Chinas population by 30 million. NEWS: From The Economist E pluribus tunum: Uniform prices for online music are no way to maximize profit: http://www.economist.com/node/14699573 SUMMARY 1. The willingness to pay of each individual consumer determines the demand curve. When price is less than or equal to the willingness to pay, the potential consumer purchases the good. The difference between willingness to pay and price is the net gain to the consumer, the individual consumer surplus. 2. Total consumer surplus in a market, the sum of all individual consumer surpluses in a market. A rise in the price of a good reduces consumer surplus; a fall in the price increases consumer surplus.

SUMMARY 3. The cost of each potential producer, the lowest price at which he or she is willing to supply a unit of that good, determines the supply curve. If the price of a good is above a producers cost, a sale generates a net gain to the producer, known as the individual producer surplus. 4. Total producer surplus in a market, the sum of the individual producer surpluses in a market, is equal to the area above the market supply curve but below the price. SUMMARY 5. Total surplus, the total gain to society from the production and consumption of a good, is the sum of consumer and producer surplus. 6. Usually, markets are efficient and achieve the maximum total surplus. Any possible reallocation of consumption or sales, or a

change in the quantity bought and sold, reduces total surplus. However, society also cares about equity. So government intervention in a market that reduces efficiency but increases equity can be a valid choice by society. SUMMARY 7. An economy composed of efficient markets is also efficient, although this is virtually impossible to achieve in reality. The keys to the efficiency of a market economy are property rights and the operation of prices as economic signals. Under certain conditions, market failure occurs, making a market inefficient. Three principal sources of market failure are attempts to capture more surplus that create inefficiencies, side effects of some transactions, and problems in the nature of the good.

KEY TERMS Willingness to pay Individual consumer surplus Total consumer surplus Consumer surplus Cost Individual producer surplus Total producer surplus

Producer surplus Total surplus Property rights Economic signal Inefficient Market failure

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