Consumer and Producer Surplus, Price Controls, and Elasticity

1. Semester 1, Lecture 4 ECO 201: Principles of Microeconomics

Lecturer: Abdurasul Abdurakhmanov
Email: a.abdurakhmonov@bmu-edu.uz

2. Module Learning Outcomes

On successful completion of the module the student will be able to:
• LO1: Explain the main principles of microeconomic concepts and
models;
• LO2: Apply the main principles of microeconomic theory, models
and tools, to interpret economic activity and issues;
• LO3: Use basic mathematical and graphical tools to model and
analyse microeconomic phenomena;
• LO4: Evaluate basic economic arguments and assess their validity
and relevance.

3. What will I learn in this chapter?

• Consumer and Producer Surplus, and the
Efficiency of Markets
• Price Ceilings and Price Floors
• Elasticity

4. Consumer Surplus

• Welfare economics
• The study of how the allocation of resources affects
economic well-being
• Benefits that buyers and sellers receive from engaging in market
transactions
• How society can make these benefits as large as possible
• In any market, the equilibrium of supply and demand
maximizes the total benefits received by all buyers and sellers
combined
4

5. Consumer Surplus

• Willingness to pay
• Maximum amount that a buyer will pay for a good
• How much that buyer values the good
• Closely related to the demand curve
• Consumer surplus
• Amount a buyer is willing to pay for a good minus
amount the buyer actually pays
• Willingness to pay minus price paid
5

6. WTP and the demand curve

Derive the
demand
schedule:
6
P (price
of iPad)
Name
WTP
Alexis
$250
Cameron
175
Fatima
300
Jamir
125
who buys
Qd
$301 & up nobody
0
251 – 300 Fatima
1
176 – 250 Alexis, Fatima
2
126 – 175
Cameron, Alexis,
Fatima
3
0 – 125
Jamir, Cameron,
Alexis, Fatima
4

7. CS and the demand curve

P
P = $260
Fatima’s
WTP
$350
$300
Fatima’s CS =
$300 – 260 = $40
$250
$200
Total CS = $40
$150
$100
$50
$0
0
1
2
3
4 Q
7

8. A lower price increases CS

P
Fatima’s
WTP
$350
$300
$250
$200
Suppose P = $220
Fatima’s CS = $300 –
220 = $80
Alexis’ CS = $250 –
220 = $30
Alexis’
WTP
$150
Total CS = $110
$100
$50
$0
0
1
2
3
4 Q
8

9. Consumer Surplus

Total consumer surplus
•The area below the demand curve and
above the price
• The height of the demand curve = the value buyers place on
the good (WTP)
• Each buyer’s CS = WTP – P
• The sum of the consumer surplus of all buyers in the market
9

10. Total consumer surplus - example

CS is the area between P
and the D curve, from 0 to
Q.
Recall: area of
a triangle equals
½ x base x height
Height =
$60 – 30 = $30.
So,
CS = ½ x 15 x $30
= $225.
10
P The demand for T-shirts
$60
P = $30, Qd = 15
50
h
40
30
20
10
D
0
0
5 10 15 20 25 30
Q

11. Consumer Surplus

A lower price raises consumer surplus
1. Existing buyers: increase in consumer surplus
• Buyers who were already buying the good at the
higher price are better off because they now pay
less
2. New buyers enter the market: increase in
consumer surplus
• Willing to buy the good at the lower price
3. Good measure of economic well-being
11

12. How Price Affects Consumer Surplus

12

13. Producer Surplus

• Cost
• Value of everything a seller must give up to produce a
good
• Measure of willingness to sell
• Closely related to the supply curve
• Producer surplus
• Amount a seller is paid for a good minus the seller’s
cost of providing it
• Price received minus willingness to sell
13

14. Cost and willingness to sell

You are the lucky owner of 3 properties with identical lawns
that need mowing. There are 3 lawn-mowing business in town
that you can hire. The table below shows their willingness to
sell:
Q: Derive the supply schedule from
the cost data.
P
Qs
$0 – 9
0
10 – 19
1
Name
cost
Jin
$10
Jada
20
20 – 34
2
Chris
35
35 & up
3
14

15. Producer surplus & the S curve

Producer surplus & the S curve
PS = P – cost
P
$40
Chris’
cost
$30
Jada’s
cost
$20
$10
Jin’s cost
Suppose P = $25.
Jin’s PS = 25 – 10 =
$15
Jada’s PS = 25 – 20
= $5
Chris’ PS = $0
Total PS = $20
$0
0
1
2
3 Q
15

16. Total producer surplus

PS is the area between P and the S
curve, from 0 to Q.
The height of this triangle is $40 – 15
= $25.
So,
PS = ½ x b x h
= ½ x 25 x $25
= $312.50
P
The supply of T-shirts
60
S
50
40
30
h
20
10
0
Q
0
16
5 10 15 20 25 30

17. A lower price reduces PS

If P falls to $30,
PS = ½ x 15 x $15
= $112.50
Two reasons for the fall in PS.
P
60
1. Fall in PS
due to sellers
leaving market
50
S
40
30
2. Fall in PS due to remaining
sellers
getting lower P
20
10
0
Q
0
17
5 10 15 20 25 30

18. How Price Affects Producer Surplus

18

19. Market Efficiency

• The benevolent social planner
• Wants to maximize the economic well-being
of everyone in society
• Economic well-being of a society
• Total surplus
• Sum of consumer and producer surplus
19

20. Market Efficiency

• Total surplus = Consumer surplus + Producer
surplus
• Consumer surplus = Value to buyers – Amount paid
by buyers
• Producer surplus = Amount received by sellers –
Cost to sellers
• Amount paid by buyers = Amount received by sellers
• Total surplus = Value to buyers – Cost to
sellers
20

21. Market Efficiency

• Efficiency
• Property of a resource allocation
• Maximizing the total surplus received by all
members of society
• Equality
• Property of distributing economic prosperity
uniformly among the members of society
21

22. Market Efficiency

• Gains from trade in a market
• Like a pie to be shared among the market participants
• The question of efficiency
• Whether the pie is as big as possible
• The question of equality
• How the pie is sliced
• How the portions are distributed among members of
society
22

23. Market Efficiency & Market Failure

Market Efficiency & Market
Failure
• Forces of supply and demand
–Allocate resources efficiently
• Several assumptions about how markets work
1. Markets are perfectly competitive
2. Outcome in a market matters only to the
buyers and sellers in that market
23

24. Market Efficiency & Market Failure

Market Efficiency & Market
Failure
• When these assumptions do not hold
– “Market equilibrium is efficient” may no longer
be true
• In the world, competition is far from perfect
–Market power
• A single buyer or seller (small group)
• Control market prices
• Markets are inefficient
24

25. Controls on Prices

• Price controls
• Policymakers believe that the market price of a good or
service is unfair to buyers or sellers
• Can generate inequities
• Taxes
• To raise revenue for public purposes
• To influence market outcomes
25

26. Controls on Prices

Price ceiling
• A legal maximum on the price at which a good
can be sold
• Rent-control laws
Price floor
• A legal minimum on the price at which a good
can be sold
• Minimum wage laws
26

27. Controls on Prices

How price ceilings affect market outcomes
• Not binding
• Set above the equilibrium price
• No effect on the price or quantity sold
• Binding constraint
• Set below the equilibrium price: Shortage
• Sellers must ration the scarce goods
• Rationing mechanisms: long lines, discrimination
according to sellers' bias
27

28. A Market with a Price Ceiling

28

29. Lines at the Gas Pump

• 1973, OPEC raised the price of crude oil
• Reduced the supply of gasoline
• Long lines at gas stations
• What was responsible for the long gas lines?
• OPEC
• Shortage of gasoline
• U.S. government regulations
• Price ceiling on gasoline
29

30. Figure 2 The Market for Gasoline with a Price Ceiling

30

31. Rent Control in the Short Run and the Long Run

Price ceiling: rent control
• Local government places a ceiling on rents
• Goal: to help the poor
• Making housing more affordable
• Critique
• Highly inefficient way to help the poor raise their
standard of living – why?
31

32. Rent Control in the Short Run and the Long Run

• Adverse effects in the short run
• Small shortage
• Reduced rents
• Adverse effects in the long run
• Landlords
• Are not building new apartments
• Are failing to maintain existing ones
• Large shortage of housing
32

33. Controls on Prices

How price floors affect market outcomes
• Not binding
• Set below the equilibrium price
• No effect on the market
• Binding constraint
• Set above the equilibrium price: Surplus
• Some sellers are unable to sell what they want
• Rationing mechanisms: not desirable
33

34. A Market with a Price Floor

34

35. The Minimum Wage

• Price floor: minimum wage
• Lowest price for labor that any employer may pay
• Fair Labor Standards Act of 1938
• Ensures workers a minimally adequate standard of
living
• 2018, federal minimum wage, $7.25/hour
• Some states mandate minimum wages above the
federal level
35

36. The Minimum Wage

• If minimum wage is above equilibrium
• Unemployment
• Higher income for workers who have jobs
• Lower income for workers who cannot find jobs
• Impact of the minimum wage on highly skilled and
experienced workers
• No effect: their equilibrium wages are well above the
minimum
36

37. How Minimum Wage Affects Labor Market

37

38.

Elasticity and Its Application
38

39. QUESTION

Suppose a university’s enrollment drops by 20
percent because tuition rises by 10 percent.
What is the price elasticity of demand?

40. ANSWER

– 20 percent
+ 10 percent
=2
The number 2 means that the quantity demanded
(enrollment) changes 2 percent for each 1 percent
change in price (tuition).

41. Questions to think

• Why may a producer want to decrease/increase the
price?
• If a producer decreases/increases price – what is the
result?
• Will a decrease in price affect the revenue? If yes,
how?
• Etc.
41

42. The Elasticity of Demand

Elasticity
• Measure of the responsiveness of quantity
demanded or quantity supplied
• To a change in one of its determinants
Price elasticity of demand (PED)
• How much the quantity demanded of a good
responds to a change in the price of that good
42

43. The Elasticity of Demand

• Price elasticity of demand (PED)
• Percentage change in quantity demanded divided by
the percentage change in price
• Elastic demand
• Quantity demanded responds substantially to changes
in price
• Inelastic demand
• Quantity demanded responds only slightly to changes
in price
43

44. The Elasticity of Demand

Determinants of price elasticity of demand
• Availability of close substitutes
• Goods with close substitutes: more elastic demand
• Necessities versus luxuries
• Necessities: inelastic demand
• Luxuries: elastic demand
• Definition of the market
• Narrowly defined markets: more elastic demand
• Time horizon
• Demand is more elastic over longer time horizons
44

45. The Elasticity of Demand

• Computing the price elasticity of demand
• Percentage change in quantity demanded divided by
percentage change in price
• Use absolute value (drop the minus sign)
• Midpoint method
• Two points: (Q1, P1) and (Q2, P2)
(Q2 − Q1 )/[(Q2 + Q1 )/ 2 ]
Price elasticity of demand =
(P2 − P1 )/[(P2 + P1 )/ 2 ]
45

46. The Elasticity of Demand

• Demand is elastic
• Price elasticity of demand > 1
• Demand is inelastic
• Price elasticity of demand < 1
• Demand has unit elasticity
• Price elasticity of demand = 1
46

47. The Elasticity of Demand

Total revenue, TR
• Amount paid by buyers and received by sellers of a
good
• Price of the good times the quantity sold (P × Q)
For a price increase
• If demand is inelastic, TR increases
• If demand is elastic, TR decreases
47

48. The Elasticity of Demand

• When demand is inelastic (elasticity < 1)
• P and TR move in the same direction
• If P ↑, TR also ↑
• When demand is elastic (elasticity > 1)
• P and TR move in opposite directions
• If P ↑, TR ↓
• If demand is unit elastic (elasticity = 1)
• Total revenue remains constant when the price
changes
48

49. The Impact of a Decrease in Price on Total Revenue

(a) Elastic demand (Ed > 1)
Price per ticket
(dollars)
40
30
A
B
20
Demand
curve
10
0
10
20
30
Quantity of tickets per concert
(thousands)
40

50. The Impact of a Decrease in Price on Total Revenue

Price per ticket
(dollars)
(b) Inelastic demand (Ed < 1)
40
C
30
D
20
10
0
Demand
curve
10
20
30
Quantity of tickets per concert
(thousands)
40

51. Other Elasticities of Demand

• Income elasticity of demand
• How much the quantity demanded of a good responds to a
change in consumers’ income
• Percentage change in quantity demanded
• Divided by the percentage change in income
• Cross-price elasticity of demand
• How much the quantity demanded of one good responds to a
change in the price of another good
• Percentage change in quantity demanded of the first good
• Divided by the percentage change in price of the second good
51