Econ 120
Consumer and Producer Surplus Transactions and their Contents
The Game Plan ● Review ● Producer and Consumer Surplus + Price Controls ● Quiz
Announcements:
Problem Set due Friday
Problem Set 2 due the following Friday→ will be posted before this Friday
Chapter 1: First Principles Be sure to: Understand concepts and how the principles are illustrated in life → Understand Problem Set and In-class practice problems
P1: Choices are Necessary because Resources Are Scarce. Key Ideas: Scarcity & Resources
P2: True Cost = Opportunity Cost Key Ideas: Implict + Explicit Cost
P3: “How much” is a decision at the margin. Key Ideas: Marginal Analysis
P4: People usually respond to incentives. Key Ideas: Unintended Consequences and Goals vs. Mechanics
P5: There are gains from Trade & Specialization Key Ideas: Focusing on a narrow task increases production
Principles, continued.
P6: Markets move towards equilibrium Key Ideas: Command vs. Market Economy
P7: Resources should be used efficiently to achieve society’s goals. Key Ideas: Allocative & Productive Efficiency
Normative & Positive Economics P8: Markets generally lead to efficiency
Key Ideas: The Invisible Hand P9: When markets don’t achieve efficiency, government intervention can improve society’s welfare
Key Ideas: Market Failure
What economic principle is represented in these examples?
1. Johnny and Madison run a clothing factory. Johnny is a really great at producing shirts. Madison is great at making pants. They agree to have Johnny make all the shirts and Madison make all the pants.
a. Gains from Specialization
2. A doctor is told that rather than receiving the same salary, they’ll instead receive a smaller base salary plus a commission based upon the amount of tests and prescriptions they provide. The doctor responds by prescribing more drugs and running more tests.
a. People usually respond to incentives 3. Companies pollute beyond what is ideal for society because the cost of pollution to them is less than the
cost of pollution for society as a whole. The local government taxes carbon emissions in order to provide a better level of pollution.
a. When markets don’t achieve efficiency, government intervention can improve society’s welfare 4. You go for a run. Near the end of each mile, you decide whether or not you think that an additional mile is
going to improve your health/mood/day enough to be worth the additional effort and loss of time. a. How much is a decision at the margin
5. A marketplace opens up in Lima, Peru and a group of people set up shop selling the same touristy items. Though initially the prices vary throughout the market, eventually everyone is selling their products at the same price-- and no one has any reason to adjust the price.
a. Markets move towards equilibrium
Practice Questions
1. What’s an explicit and implicit cost of going on vacation? a. Explicit → paying for the flight Implicit → how else you could have spent the time
2. Suppose we can’t produce any more of one good without producing less of a different good. Are we being allocatively efficient? a. Not necessarily. We are, however, being productively efficient.
3. Is “The US should have universal healthcare” a positive or a normative statement? a. Normative -- it’s a prescription of how the economy ought to operate.
Chapter 2: PPF
Feasible v. Infeasible?
Efficient v. Inefficient?
Opportunity Cost a consumer good in Range of B to C?
Principle of Increasing Cost and the “Bowed Outward” shape of the PPF
Economic Growth
Chapter 2: PPF
Efficient Feasible
Above PPF
N/A No
On PPF
Yes Yes
Below PPF
No Yes
Chapter 2: PPF
OC = (30-60)/(75-60) = -2
Principle of Increasing Cost = As I produce More of the good, the opportunity cost Increases.
Economic Growth:
1. Increase in resources 2. Technological improvement
Chapter 3: Supply and Demand ● Law of Demand ● Law of Supply ● Supply and Demand Schedules vs. Curves ● The Shifters
○ iRent ■ Input Costs, Related Goods, Expectations, Number of Producers, Technology ■ Income, Related Goods, Expectations, Number of Consumers, Tastes
Illustrating Shifts using Schedules Suppose there’s a technological improvement. Qs increases across prices. Supply (B) Supply (A) Demand Price Quantity
Supplied (Before)
1 1
2 3
3 6
4 9
Price Quantity Supplied (After)
1 8
2 10
3 13
4 16
Price Quantity Demanded
1 14
2 10
3 6
4 2
Suppose we find out our good has huge health benefits. What happens to demand?
→
Price Quantity Demanded
1 14
2 10
3 6
4 2
Price Quantity Demanded
1 20
2 16
3 12
4 8
Practice Problems: What happens to Eq. Price & Quantity?
1. Suppose we are looking at the market for the basketballs in Chicago. Two events occur: a. The Bulls are doing really well-- and basketball increases in popularity. This effect dominates.
i. Demand increases b. There’s an increase in the amount of basketball stores around the city.
i. Supply increases 1. Quantity increases. Price change is ambiguous.
Consumer and Producer Surplus: Motivation How do measure the benefits of a transaction?
How can we say a policy is good or bad for people?
Why should we think that some markets, like competitive ones, are preferable to monopolies?
Today’s class builds a framework for addressing these questions.
Gain = “Benefit” - “Cost”
Consumer Surplus (CS) What do consumers gain from a transaction?
Consumer Surplus = Willingness to Pay - Price
(if the consumer buys, Willingness to Pay > Price → otherwise, CS = 0)
“Benefit” = Willingness to Pay & “Cost” = Price
Willingness to Pay = The most one would pay for a good/service
Practice Problems
1. Leon goes to buy a shirt. His willingness to pay is $10. The shirt has a price of $5. What’s the consumer surplus?
2. Stacey is willing to pay $2 for a water bottle. The water bottle has a price of $2.50. What’s the consumer surplus?
Practice Problems
1. Leon goes to buy a shirt. His willingness to pay is $10. The shirt has a price of $5. What’s the consumer surplus? a. CS = $10-$5 = $5
2. Stacey is willing to pay $2 for a water bottle. The water bottle has a price of $2.50. What’s the consumer surplus? a. Price > Willingness to Pay → $0.
Individual vs. Total Consumer Surplus
● Individual Consumer Surplus: the consumer surplus an individual achieves from a transaction.
● Total Consumer Surplus: the sum of individual consumer surpluses achieved by all the buyers of a good in a market.
Find the Individual and Total Consumer Surplus
Total Consumer Surplus = ?
Potential Buyer
Willingness to Pay
Price Individual Consumer Surplus
Aleisha 40 18
Johnny 30 18
Cassandra 20 18
Nico 10 18
Find the Individual and Total Consumer Surplus
Total Consumer Surplus = 22 + 12 + 2 + 0 = 36
Potential Buyer
Willingness to Pay
Price Individual Consumer Surplus
Aleisha 40 18 22
Johnny 30 18 12
Cassandra 20 18 2
Nico 10 18 0
What if the price changes? Total Consumer Surplus = ?Potential
Buyer Willingness to Pay
Price Individual Consumer Surplus
Aleisha 40 24
Johnny 30 24
Cassandra 20 24
Nico 10 24
What if the price changes? Total Consumer Surplus = 16 + 2 + 0 + 0 = 18
Price = 18 → CS = 36
Price = 24 → CS = 22 Key Idea = When price increases, CS generally decreases. When price decreases, CS generally increases.
Potential Buyer
Willingness to Pay
Price Individual Consumer Surplus
Aleisha 40 24 16
Johnny 30 24 6
Cassandra 20 24 0
Nico 10 24 0
Breaking down a price change
Price drops → More transactions and “better” transactions Price goes up → Less transactions and “worse” transactions
Potential Buyer
Willingness to Pay
Price Individual Consumer Surplus
Aleisha 40 18 22
Johnny 30 18 12
Cassandra 20 18 2
Nico 10 18 0
Potential Buyer
Willingness to Pay
Price Individual Consumer Surplus
Aleisha 40 24 16
Johnny 30 24 6
Cassandra 20 24 0
Nico 10 24 0
Visualizing the process What’s the Total Consumer Surplus? Price = 18
We can use everyone’s Willingness to Pay to create a Demand Curve
Visualizing the process Total Consumer Surplus = (40 - 18) + (30- 18) + (20 - 18) = 22 + 12 + 2 = 36
Suppose Price = 24 → What’s the new CS?
Suppose Price = 24 → What’s the new CS? (40-24) + (30-24) = 16 + 6 = 22
Competitive Markets with Many Consumers Demand = Relationship between Willingness to Pay and Quantity Demanded
What is the market willing to pay for any quantity level?
Finding Consumer Surplus using Demand Curves Area = (.5)(base)(height) CS = Area under Demand Curve and
Above the price
What’s the CS here? *Price = 20
Finding Consumer Surplus using Demand Curves What’s the CS here?
½ * Base * Height ½ * 200 * (40-20) = $2000
Suppose the price drops to 10. What’s the new CS?
Suppose the price drops to 10. What’s the new CS?
½ * 300 * (40-10) = $4500
Price decreased. CS increased.
Breaking it down with a graph
Producer Surplus: What Producers Gain “Benefit” = Price “Cost” = Cost
Cost = lowest price at which a potential seller is willing to sell an item
Producer Surplus = Price - Cost (if the producer sells the good → otherwise, PS = 0)
Individual vs. Total Producer Surplus Individual Producer Surplus → Price - Cost if Price > Cost, otherwise 0
Total Producer Surplus → Sum of Individual Producer Surplus for all producers
What’s the total producer surplus? Potential Seller Cost Price Individual Producer Surplus
Tony’s 4 6
Nottoli’s 7 6
Rex’s 5 6
Gio’s 9 6
Individual vs. Total Producer Surplus Individual Producer Surplus → Price - Cost if Price > Cost, otherwise 0
Total Producer Surplus = 2 + 1 = 3
Potential Seller Cost Price Individual Producer Surplus
Tony’s 4 6 2
Nottoli’s 7 6 0
Rex’s 5 6 1
Gio’s 9 6 0
What if the price changes? What’s the new total producer surplus?
Potential Seller Cost Price Individual Producer Surplus
Tony’s 4 8
Nottoli’s 7 8
Rex’s 5 8
Gio’s 9 8
What’s the new total producer surplus? PS = 4+1+3 = 8
Potential Seller Cost Price Individual Producer Surplus
Tony’s 4 8 4
Nottoli’s 7 8 1
Rex’s 5 8 3
Gio’s 9 8 0
What if the price changes? At $6 → PS = 3
At $8 → PS = 8
Potential Seller
Cost Price Individual Producer Surplus
Tony’s 4 8 4
Nottoli’s 7 8 1
Rex’s 5 8 3
Gio’s 9 8 0
Potential Seller
Cost Price Individual Producer Surplus
Tony’s 4 6 2
Nottoli’s 7 6 0
Rex’s 5 6 1
Gio’s 9 6 0
What if the price changes? Price Increases → More transactions and “better” transactions → PS increases
Price decreases → Less transactions and “worse” transactions → PS decreases
Potential Seller
Cost Price Individual Producer Surplus
Tony’s 4 8 4
Nottoli’s 7 8 1
Rex’s 5 8 3
Gio’s 9 8 0
Potential Seller
Cost Price Individual Producer Surplus
Tony’s 4 6 2
Nottoli’s 7 6 0
Rex’s 5 6 1
Gio’s 9 6 0
Visualizing graphically
What’s the PS?
Visualizing graphically
PS = (6-4) + (6-5) = $3
What if the price changes? PS = (8-4) + (8-5) + (8-7) =4+3+1 = $8
PS at $6 → $3 PS at $8 → $8
Price increases → PS increases Price decreases → PS decreases
Competitive Markets with Many Producers What’s the Producer Surplus?
Producer Surplus =
½ * 100 * (10-0) = $500
What if the Price Changes? What’s the Producer Surplus?
½ * Base * Height
½ * 200 * (20-0) = $2000
Price drops → PS drops
Price goes up → PS goes up
Price changes
Total Surplus = Producer Surplus + Consumer Surplus
TS = PS + CS → TS = (Willingness to Pay - Price) + (Price - Cost) TS = Willingness to Pay - Cost
Key idea: A transaction creates Surplus if Willingness to Pay is Greater than Cost.