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CHAPTER
7
M
ARKET
E
FFICIENCY AND
W
ELFARE
7.1
Consumer Surplus and Producer Surplus
7.2
The Welfare Effects of Taxes, Subsidies,
and Price Controls
I
n earlier chapters, we saw how the market forces
of supply and demand allocate society’s scarce
resources. However, we did not discuss whether
this outcome was desirable or to whom. Are the
price and output that result from the equilibrium
of supply and demand right from society’s stand-
point?
Using the tools of consumer and producer
surplus, we can demonstrate the
efficiency
of a
competitive market. In other words, we can
show that the equilibrium price and quantity in
a competitive market maximize the economic
welfare of consumers and producers. Maximizing
total surplus (the sum of consumer and producer
surplus) leads to an efficient allocation of resources.
Efficiency makes the size of the economic pie as
large as possible. How we distribute that eco-
nomic pie (equity) is the subject of future chap-
ters. Efficiency can be measured on objective,
positive grounds while equity involves normative
analysis.
We can also use the tools of consumer and
producer surplus to study the
welfare effects
of
government policy—rent controls, taxes, and agri-
cultural support prices. To economists,
welfare
does
not mean a government payment to the poor;
rather, it is a way that we measure the impact of a
policy on a particular group, such as consumers or
producers. By calculating the changes in producer
and consumer surplus that result from government
intervention, we can measure the impact of such
policies on buyers and sellers. For example, econo-
mists and policymakers may want to know how
much a consumer or producer might benefit or be
harmed by a tax or subsidy that alters the equilib-
rium price and quantity.
Let’s begin by presenting the most widely used
tool for measuring consumer and producer welfare.
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Fundamentals II
MODULE 2
SECTION
7.1
Consumer Surplus and
Producer Surplus
What is consumer surplus?
What is producer surplus?
How do we measure the total gains from
trade?
CONSUMER SURPLUS
In a competitive market, consumers and producers
buy and sell at the market equilibrium price.
However, some consumers will be willing and able to
pay more for the good than they have to. That is,
what a consumer actually pays for a unit of a good is
usually less than the amount she is
willing
to pay. For
example, you would be willing and able to pay far
more than the market price for a rope ladder to get
out of a burning building. You would be willing to pay
more than the market
price for a tank of gaso-
line if you had run out
of gas on a desolate
highway in the desert.
Consumer surplus
is
the monetary difference
between the amount a
consumer is willing and
able to pay for an addi-
tional unit of a good and
what the consumer actually pays—the market price.
Consumer surplus for the whole market is the sum of all
the individual consumer surpluses for those consumers
who have purchased the good.
consumer surplus
the difference between the price a
consumer is willing and able to pay
for an additional unit of a good and
the price the consumer actually
pays; for the whole market, it is the
sum of all the individual consumer
surpluses
Imagine it is 115 degrees in the shade. Do you think you would
get more consumer surplus from your first glass of iced tea
than you would from a fifth glass?
iced tea has a step-like shape. This is demonstrated by
Julie’s willingness to pay $4 and $2 successively for the
first two glasses of iced tea. Thus, Julie will receive $3
of consumer surplus for the first glass ($4
$1) and
$1 of consumer surplus for the second glass ($2
$1),
for a total consumer surplus of $4, as seen in Exhibit
1. Julie will not be willing to purchase the third glass,
because her willingness to pay is less than its price
($0.50 versus $1.00).
In Exhibit 2, we can easily measure the consumer
surplus in the market by using a market demand curve
rather than an individual demand curve. In short, the
market consumer surplus is the area under the market
demand curve and above the market price (the shaded
area in Exhibit 2). The market contains millions of
potential buyers, so we will get a smooth demand
curve. Because the demand curve represents the mar-
ginal benefits consumers receive from consuming an
additional unit, we can conclude that all buyers of
chocolate receive at least some consumer surplus in the
market because the marginal benefit is greater than the
market price—the shaded area in Exhibit 2.
MARGINAL WILLINGNESS TO PAY
FALLS AS MORE IS CONSUMED
Suppose it is a hot day and iced tea is going for $1 per
glass, but Julie is willing to pay $4 for the first glass
(point a), $2 for the second glass (point b), and $0.50
for the third glass (point c), reflecting the law of
demand. How much consumer surplus will Julie
receive? First, it is important to note the general fact
that if the consumer is a buyer of several units of a
good, the earlier units will have greater marginal value
and therefore create more consumer surplus, because
marginal willingness to pay
falls as greater quantities
are consumed in any period. In fact, you can think of
the demand curve as a marginal benefit curve—the
additional benefit derived from consuming one more
unit. Notice in Exhibit 1, that Julie’s demand curve for
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Market Efficiency and Welfare
CHAPTER 7
Julie’s Consumer Surplus
for Iced Tea
Impact of an Increase in
Supply on Consumer Surplus
SECTION
7.1
E
XHIBIT
1
SECTION
7.1
E
XHIBIT
3
a
Q
1
can now be purchased
at a lower price
A
Maximum price willing
to pay for 1st glass
$4
S
1
$3
S
2
B
$3
P
1
b
Maximum price willing
to pay for 2nd glass
A lower price makes it
advantageous for buyers to
expand their purchases
$2
C
P
2
$1
D
Market price
$1
c
Maximum price willing
to pay for 3rd glass
Market
Demand
$.50
D
ICED TEA
0
Q
1
Q
2
1
2
3
0
Quantity
Quantity of Iced Tea
(glasses per day)
As a result of the increase in supply, the price falls
from
P
1
to
P
2
. The initial consumer surplus at
P
1
is the
area
P
1
AB.
The increase in the consumer surplus from
the fall in price is from
P
1
to
P
2
.
Julie receives $3 of consumer surplus for the first glass
of iced tea and $1 of consumer surplus for the second
glass. Her total consumer surplus is $4.
SECTION
7.1
E
XHIBIT
2
lower price. Conversely, a decrease in supply and
increase in price will lower your consumer surplus.
Exhibit 3 shows the gain in consumer surplus asso-
ciated with, say, a technological advance that shifts the
supply curve to the right. As a result, equilibrium price
falls (from
P
1
to
P
2
) and quantity rises (from
Q
1
to
Q
2
).
Consumer surplus then increases from area
P
1
AB to
area
P
2
AC, or a gain in consumer surplus of
P
1
BC
P
2
.
The increase in consumer surplus has two parts. First,
there is an increase in consumer surplus, because
Q
1
can
now be purchased at a lower price; this amount of addi-
tional consumer surplus is illustrated by area
P
1
BD
P
2
in
Exhibit 3. Second, the lower price makes it advanta-
geous for buyers to expand their purchases from
Q
1
to
Q
2
. The net benefit to buyers from expanding their con-
sumption from
Q
1
to
Q
2
is illustrated by area BCD.
Consumer Surplus
Consumer surplus
in the market
Market price
P
1
Marginal willingness
to pay for last unit
Market
Demand
0
Q
1
Quantity of Chocolate
(billions of pounds per year)
The area below the market demand curve but above
the market price is called consumer surplus. It is repre-
sented by the shaded area. The market demand curve
is smooth because many buyers purchase chocolate
each year.
PRODUCER SURPLUS
As we have just seen, the difference between what
a consumer would be willing and able to pay for a
given quantity of a
good and what a con-
sumer actually has to
pay is called con-
sumer surplus. The
parallel concept for
producers is called
producer surplus.
Producer surplus
is
the difference between
what a producer is
PRICE CHANGES AND CHANGES
IN CONSUMER SURPLUS
Imagine that the price of your favorite beverage fell
because of an increase in supply. Wouldn’t you feel
better off? An increase in supply and a lower price
will increase your consumer surplus for each unit you
were already consuming and will also increase your
consumer surplus from additional purchases at the
producer surplus
the difference between what a pro-
ducer is paid for a good and the cost
of producing that unit of the good; for
the market, it is the sum of all the
individual sellers’ producer surpluses—
the area above the market supply
curve and below the market price
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Fundamentals II
MODULE 2
using what you’ve learned
Consumer Surplus and Elasticity
Will a price increase lead to a larger loss in consumer surplus when
demand is relatively elastic or relatively inelastic?
When the price rises from P
1
to P
2
, consumer surplus falls by area c
when the demand curve is relatively elastic but falls by area c
Consumer Surplus
and Elasticity
SECTION
7.1
E
XHIBIT
4
Q
A
d
when the demand curve is relatively inelastic (see Exhibit 4). That is, the loss
in consumer surplus is greater when the demand curve is relatively inelastic.
For example, if a tax is levied on a good with a relatively inelastic demand,
consumers would lose more than if the tax is levied on a good with a rela-
tively elastic demand.
+
Relatively inelastic
demand curve (at
E
1
)
b
a
E
2
P
2
E
3
d
c
E
1
Relatively elastic
demand curve (at
E
1
)
P
1
Relatively Inelastic
Relatively Elastic
Demand Curve
Demand Curve
D
2
D
1
Consumer Surplus at P
1
a
+
b
+
c
+
d
a
+
c
0
Q
3
Q
2
Q
1
Consumer Surplus at P
2
a
+
b
a
Quantity
Consumer Surplus Loss
−
c
−
d
−
c
paid for a good and
the cost of producing
one unit of that good.
The supply curve
shows the minimum
amount that sellers
must receive to be willing to supply any given
quantity; that is, the supply curve reflects the mar-
ginal cost to sellers. The
marginal cost
is the cost
of producing one more unit of a good. In other
words, the supply curve is the marginal cost curve,
just like the demand curve is the marginal benefit
curve. Because some units can be produced at a
cost that is lower than the market price, the seller
receives a surplus, or a net benefit, from producing
those units. For example, in Exhibit 5, the market
price is $5. Say the firm’s marginal cost is $2 for
the first unit, $3 for the second unit, $4 for the
third unit, and $5 for the fourth unit. Because pro-
ducer surplus for a particular unit is the difference
between the market price and the seller’s cost of
producing that unit, producer surplus would be as
follows: The first unit would yield $3; the second
unit would yield $2; the third unit would yield $1;
and the fourth unit would add no more to pro-
ducer surplus, because the market price equals the
seller’s cost.
SECTION
7.1
E
XHIBIT
5
A Firm’s Producer Surplus
marginal cost
the cost of producing one more unit
of a good
Supply
$5
Price
PS
$1
4
PS
$2
PS
$3
3
MC
$5
2
MC
$4
MC
$3
MC
$2
1
0
1
234
Quantity per Week (q)
The firm’s supply curve look like a staircase. The marginal
cost is under the stair and the producer surplus is above
the stair and below the market price for each unit.
When there are a lot of producers, the supply curve
is more or less smooth, like in Exhibit 6. Total producer
surplus for the market is obtained by summing all
the producer surpluses of all the sellers—the area
above the market supply curve and below the
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Market Efficiency and Welfare
CHAPTER 7
Consumer and Producer
Surplus
SECTION
7.1
E
XHIBIT
6
SECTION
7.1
E
XHIBIT
8
Market Producer Surplus
Market Supply
Curve
Market
Supply
$8
7
6
C
A
CS
5
4
3
CS
CS
E
$5
Market Price
Producer
Surplus
PS
D
PS
PS
B
2
1
Market
Demand
0
1
2
Quantity
(millions of units/year)
34 5
0
50,000
Quantity per Week
The market producer surplus is the area above the
supply curve and below the market price up to the
quantity produced, 50,000 units.
Increasing output beyond the competitive equilibrium
output, 4 million units, decreases welfare, because the
cost of producing this extra output exceeds the value
the buyer places on it—producing 5 million units
rather than 4 million units leads to a deadweight loss
of area ECD. Reducing output below the competitive
equilibrium output level, 4 million units, reduces total
welfare, because the buyer values the extra output by
more than it costs to produce that output—producing
3 million units rather than 4 million units leads to a
deadweight loss of area EAB.
market price up to the quantity actually produced.
Producer surplus is a measurement of how much
sellers gain from trading in the market.
Suppose an increase in market demand causes the
market price rises, say from
P
1
to
P
2
; the seller now
receives a higher price per unit, so additional pro-
ducer surplus is generated. In Exhibit 7, we see the
additions to producer surplus. Part of the added sur-
plus (area
P
2
DB
P
1
) is due to a higher price for the
quantity already being produced (up to
Q
1
) and part
(area DCB) is due to the expansion of output made
profitable by the higher price (from
Q
1
to
Q
2
).
SECTION
7.1
E
XHIBIT
7
Impact of an Increase in
Demand on Producer Surplus
A higher price for quantity
already being produced
Market
Supply
MARKET EFFICIENCY AND PRODUCER
AND CONSUMER SURPLUS
With the tools of consumer and producer surplus, we
can better analyze the total gains from exchange. The
demand curve represents a collection of maximum
prices that consumers are willing and able to pay for
additional quantities of a good or service. The supply
curve represents a collection of minimum prices that
suppliers require to be willing and able to supply each
additional unit of a good or service. Both are shown
in Exhibit 8. For example, for the first unit of output,
the buyer is willing to pay up to $7, while the seller
would have to receive at least $1 to produce that unit.
However, the equilibrium price is $4, as indicated by
the intersection of the supply and demand curves. It is
clear that the two would gain from getting together
and trading that unit, because the consumer would
D
P
2
C
Expansion of output from
Q
1
to
Q
2
made profitable
because of higher price
P
1
B
D
2
D
1
A
0
Q
1
Q
2
Quantity
A higher market price due to an increase in market
demand will increase total producer surplus. The initial
producer surplus at
P
1
is the area AB
P
1
. The increase in
producer surplus from the higher price is area
P
2
CB
P
1
.
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