Topic 2:
Consumers Surplus,
Producers Surplus and
Market Efficiency
ECON 1210B
Economics and Society
Spring 2019
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Introduction
⚫ By now we know markets allocate resources by the
forces of supply and demand
⚫ Why such allocations are good, and in what sense?
⚫ Welfare economics is the study of how the
allocation of resources affects economic well-being
⚫ We will introduce the concepts of
⚫ Consumer Surplus
⚫ Producer Surplus
⚫ Efficiency
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Consumer Surplus (CS)
⚫ How may buyers benefit from a market
transaction?
⚫ The key is to distinguish value and price
⚫ Willingness to Pay (WTP): the maximum
amount that a buyer will pay for a good
⚫ WTP measures how much the buyer
values the good
⚫ CS = Willingness to Pay – Actual Payment
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Demand Curve As the
MB Curve
⚫ To identify CS graphically, we introduce
another interpretation of the demand curve
⚫ At any quantity, the price given by the
demand curve shows the willingness to pay
of the marginal buyer
⚫ A demand curve reflects buyers’ willingness
to pay
⚫ Demand curve is also called a marginal
benefit (MB) curve
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CS and the Demand Curve
CS is the area P The demand for shoes
between P and the $ 60
D curve, from 0 to Q
50
h
Suppose P = $30 40
30
CS
20
= 0.5 x 15 x $30
= $225 10
D
0 Q
0 5 10 15 20 25 30
How a Higher Price Reduces CS
If P rises to $40
P
New CS 1. Fall in CS
60
= 0.5 x 10 x $20 due to buyers
= $100 50 leaving market
2 reasons for the 40
fall in CS… 30
2. Fall in CS due to 20
remaining buyers 10
paying higher P D
0 Q
0 5 10 15 20 25 30
Producer Surplus (PS)
⚫ Now we want to know how sellers may
benefit from a market transaction
⚫ The key is to distinguish cost and price
⚫ Willingness to sell: minimum amount a seller
will accept to provide a good
⚫ Determined by the marginal cost (MC)
⚫ PS = Payment Received – Willingness to Sell
= Payment Received – Seller’s Cost
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Supply Curve As the
MC Curve
⚫ To identify PS graphically, notice that…
⚫ At any quantity, the price given by the supply
curve shows the willingness to sell of the
marginal seller
⚫ A supply curve reflects sellers’ willingness to
sell
⚫ Supply curve is also called a marginal cost
(MC) curve
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PS and the Supply Curve
PS is the area P The supply of shoes
between P and the
60
S curve, from 0 to Q
50 S
Suppose P = $40
40
PS
30
= 0.5 x 25 x $25 h
= $312.5 20
10
0 Q
0 5 10 15 20 25 30
How a Lower Price Reduces PS
If P falls to $30, P 1. Fall in PS
New PS 60 due to sellers
= 0.5 x 15 x $15 leaving market S
50
= $112.5
40
2 reasons for the
fall in PS… 30
2. Fall in PS due to 20
remaining sellers 10
getting lower P
0 Q
0 5 10 15 20 25 30
What do CS, PS, and Total
Surplus Measure?
⚫ CS = (value to buyers) – (amount paid by buyers)
⚫ CS measures the benefit buyers receive
from participating in the market
⚫ PS =(amount received by sellers) – (cost to sellers)
⚫ PS measures the benefit sellers receive
from participating in the market
⚫ Total surplus = CS + PS
⚫ TS measures the total gains from transaction/
trade in a market
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Market Efficiency
⚫ An allocation of resources is efficient if it
maximizes total surplus
⚫ Efficiency means:
⚫ Raising or lowering the quantity of a good
would not increase total surplus
⚫ The goods are being produced by the
producers with lowest cost
⚫ The goods are being consumed by the
buyers who value them most highly
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Evaluating the Market Equilibrium
P
Market eqm: 60
P = $30 50 S
Q = 15,000
40 CS
Total surplus 30
PS
= CS + PS 20
10
Is the market eqm D
efficient? 0 Q
0 5 10 15 20 25 30
Which Buyers Consume the Good?
Every buyer P
whose WTP is 60
≥ $30 will buy
50 S
Every buyer
40
whose WTP is
< $30 will not 30
So, the buyers who 20
value the good most 10
highly are the ones D
who consume it 0 Q
0 5 10 15 20 25 30
Which Sellers Produce the Good?
P
Every seller whose
cost is ≤ $30 will 60
produce the good 50 S
Every seller whose 40
cost is > $30 will not 30
So, the sellers with 20
the lowest cost 10
produce the good D
0 Q
0 5 10 15 20 25 30
Does Eqm Q Maximize Total Surplus?
At Q = 20,
P
cost of producing
the marginal unit 60
is $35 50 S
value to consumers 40
of the marginal unit
is only $20 30
Hence, can increase 20
total surplus 10
by reducing Q D
0 Q
This is true at any Q
greater than 15 0 5 10 15 20 25 30
Does Eqm Q Maximize Total Surplus?
At Q = 10,
P
cost of producing
the marginal unit 60
is $25 50 S
value to consumers 40
of the marginal unit
is $40 30
Hence, can increase 20
total surplus 10
by increasing Q D
0 Q
This is true at any Q
less than 15 0 5 10 15 20 25 30
Efficiency of the Eqm
Figure 8 The Efficiency Quantity
of the Equilibrium Quantity
Price
Supply
Value Cost
to to
buyers sellers
Cost Value
to to
sellers buyers Demand
0 Equilibrium Quantity
quantity
Value to buyers is greater Value to buyers is less
than cost to sellers. than cost to sellers.
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Evaluating the Market Eqm:
Summary
⚫ The market eqm is efficient:
⚫ The eqm Q maximizes total surplus
⚫ The goods are produced by the producers
with lowest cost,
⚫ and consumed by the buyers who value
them most highly
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Evaluating the Market Eqm:
Summary
⚫ Adam Smith’s “invisible hand” idea
⚫ When consumers and producers pursue
their own self-interest and interact in
markets...
⚫ Market transactions send resources to their
highest valued use in society
⚫ Govt cannot improve on the market outcome
⚫ Laissez faire (French for “allow them to do”)
⚫ govt should not interfere with the market
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Why Non-Market Allocations
Are Usually Bad
⚫ Suppose the allocation of resources were
instead determined by a central planner
⚫ e.g. Communist leaders of Soviet Union
⚫ To choose an efficient allocation, the planner
would need to know every seller’s cost
and every buyer’s WTP, for each of the
thousands of goods produced in the economy
⚫ This is practically impossible, so centrally
planned economies are never very efficient
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Obstacles to Efficiency
⚫ Inefficiency can occur because:
⚫ Too little of an item is produced:
⚫ underproduction
⚫ Too much of an item is produced:
⚫ overproduction
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Underproduction
The efficient quantity is 10,000 pizzas a day
If production is restricted
to 5,000 pizzas a day,
there is underproduction
and the quantity is
inefficient
A deadweight loss
equals the decrease in
total surplus (the gray
triangle)
This loss is a social loss
Overproduction
Again, the efficient Q is 10,000 pizzas a day
If production is
expanded to 15,000
pizzas a day, a
deadweight loss arises
from overproduction
This loss is a social
loss
Obstacles to Efficiency
⚫ In markets, underproduction or
overproduction arise when there are
⚫ Price and quantity regulations
⚫ Taxes and subsidies
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Obstacles to Efficiency:
Market Failures
⚫ In the real world, sometimes there are
market failures, when unregulated markets
fail to allocate resources efficiently
⚫ Externalities
⚫ Public goods and common resources
⚫ When markets fail, public policy may remedy
the problem and increase efficiency
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