PRODUCER AND CONSUMER SURPLUS Colander 8 th ed Ch. 8 (179 – 180) Colander 9 th ed Ch. 7 Baumol Ch....

PRODUCER AND CONSUMER SURPLUS

Colander 8th ed Ch. 8 (179 – 180)Colander 9th ed Ch. 7Baumol Ch. 5 (94-96)

Market Demand: Value consumers place on each unit purchased

The distance to the Demand curve tells us how much

consumers are willing to pay for a given quantity of the good.

The distance to the Demand curve tells us how much the last

unit is worth to the consumer

Willing to pay $10 for

the 100th unit

Willing to pay $1 for the 500th unit

When she buys 100 units: she is willing to pay $10 only for the last unit

Willingness to Pay

$10 for one unit

$8 for the second unit

$6 for the third unit

Consumer Surplus The difference between the

price the consumer actually pays and the price s/he is

willing to pay.

Willingness to Pay

5If the price is $0.05

$3Consumer Actually

pays $0.05 x 180 = $9

Long distance phone service

Minutes

Consumer is willing to

pay $24 for 180 minutes

Consumer Surplus = 24 – 9= 15

Cents per minute

Willingness to Pay

Consumer Surplus

If the price is $0.05

Consumer Actually

Consumer Surplus

1 Minute intervals180 minutes

What the consumer

actually pays = 0.05*180

Consumer surplus

Consumer Surplus

The amount consumers are willing to pay MINUS amount they actually pay

The area below the demand curve and above the price the consumer

Consumer Surplus

1 Minute intervals180 minutes

What the consumer

actually pays = Price x Quantity

Consumer surplus = Area of triangle

Consumer surplus in a Perfectly Competitive market

Supply = Cost

Number of units purchased

Consumer Surplus

Price Consumer

PaysWhat the consumer actually pays = Price

x Quantity

Market Supply

The distance to the Supply curve tells us how much it costs to produce a given

quantity of the good.

The distance to the Supply curve tells us the cost of producing the last unit

Cost $1

Cost $3

Producer would be willing to produce

this unit if and only if the price covers

the costPrice

Quantity Produced

If the price is $3 per unit, this price

covers the cost of producing the first

and the second units

Cost $10

If the price is $10 per unit, this price

covers the cost of producing 20 units

Producer SurplusThe difference between the per unit

price the producer receives and his/her per unit cost.

Producer Surplus

S = Cost

If The market price is $6

Producer Surplus = 18 – 12 = 6

Cost=12 TR = $18

PS = 6The area above the supply curve and below the price the producer

receives

Producer Surplus under Perfect Competition

Supply = Cost

Quantity Sold

Price producer receives

Consumer surplus in a Perfectly Competitive market:

Supply = Cost

Equilibrium Quantity = 4000

CS = Triangle Area

Equilibrium Price = $5

Triangle Area = Base x Height x ½Triangle Area = 4000 x (10-5) x 1/2

Producer Surplus under Perfect Competition

Supply/Cost

PS = Triangle

Triangle Area = Base x Height x ½Triangle Area = 4000 x (5-2) x 1/2

Perfect Competition

Supply/Cost

Qe=4000

100th 1000th

S (cost)

Cost $10$10

$1Cost $1

Willing to pay $10

D (Value given by consumer)Willing to

pay $1

Optimum Output Level

S (cost)

Willing to pay

D (Value given by consumer)

Willing to pay

Optimum Output Level is the Equilibrium Quantity

Equilibrium QThese units should be produced

These units should NOT be

produced

Consumers are willing to pay the cost of bringing these units to market

Consumers are not willing the pay the

cost of bringing these units to

market

Equilibrium Quantity

PracticeCalculate Consumer and Producer Surplus at

equilibrium

THE EFFECT OF PRICE CONTROLS

Colander 8th ed. Ch. 8 (187-188)Colander 9th ed. Ch. 7Baumol Ch. 4

A Price Ceiling: Government prohibits any price above $3

Qd =6000

Shortage

Qs =2000

Consumer surplus when

only 2000 units are purchased

due to shortage

Lost consumer and producer surplus when only 2000

units are purchased and sold at $3

Producer surplus when

only 2000 units are sold

Producer surplus when 4000 units are purchased at

equilibrium

Consumers purchase 2000 at $3 per unit

Consumer surplus when 4000 units are purchased at

equilibrium10

The Effect of a Price Ceiling

CS at equilibrium

Gain to consumerLoss to Consumer7,300

CS: Area below DAbove Price

The Effect of a Price Ceiling

SLoss to Producer

600300

PS: Area below Price

Above S

A Price Ceiling has the same effect of charging a Tax to Producers and giving that money as a

subsidy to Consumers

Loss to Producer

Gain to consumer

TaxSubsidy

Welfare Loss From Price Ceiling

A Price Floor: Government prohibits any price below $8

Qs =6000

Surplus

Qd =2000

4000Consumers

purchase 2000 at $8 per unit

Consumer surplus when

only 2000 units are purchased due to price

above equilibrium

Producer surplus when

only 2000 units are sold due to

price above equilibrium

Consumer surplus when 4000 units are purchased at

equilibrium

Producer surplus when 4000 units are purchased at

equilibrium

Lost consumer and producer surplus when only 2000

units are purchased and sold at $8

The Effect of a Price Floor on Consumer Surplus

3Loss to Consumer

The Effect of a Price Floor on Producer Surplus

3Loss to Producer

Gain to Producer

2CS at Equilibrium

A Price Floor has the same effect as charging a Tax to Consumers and giving that money as a subsidy to

Producers

Loss to Consumer

Gain to Producer

Tax Subsidy

Loss of Surplus to Society

Loss to Consumer

Loss to Producer

Welfare Loss from Price Floor

P SP S

Welfare Loss from Price Floor

Most governments around the world intervene actively in the operation of their agricultural

markets.

Governments in poor Third World countries

• Though numerous, farmers do not organize politically and therefore have much less political power than people in the cities

• To gain favor with their more politically powerful urban residents. Governments impose price controls to keep food prices artificially low.

• By artificially depressing the price of food, Third World governments reduce incentives for farmers to produce and reduce the availability of food from domestic sources

By artificially depressing the price of food, Third World governments create a permanent shortage of food.

Fair Trade Coffee• Agricultural prices are low because there is

overproduction.• To solve overproduction, only the most efficient

farmers should remain in business.• The market mechanism ensures that only those with

lower costs (the most efficient) remain in business.• If prices are held artificially high, farmers will not

have an incentive to leave this industry and find alternatives.

• Fair trade prices perpetuate the surplus…not so good for the farmers after all.

Why Agricultural Price Supports?

• Rural districts have greater political power.

• Farmers are often viewed as disadvantaged.

• Farm prices are volatile from uncertain weather conditions.

Floors

Forms of Price Supports

1. Government buys any quantity of a product at the guaranteed "support price."

For example In the U.S. the Commodity Credit Corporation buys to support the price of milk.

The CCC disposes of the commodities in ways that will not depress the domestic market price.

For example, dairy products are often given away to low-income people, in the school lunch program, and as foreign aid. A price

floorA price floor

Effect of a Price Floor

No transactions allowed below $2Price paid by consumers

increasesQuantity decreases

Use tax payer money to purchase Surplus 60-20 = 40$2.5

Other Forms of Price Supports

2. Limiting production. Each farmer is given a quota that stipulates

how much he can sell in a given year. Example: peanuts in the United States and milk in

Canada. Limiting supply can raise market prices as long

as government inspectors monitor the market to ensure that no production above the quota is sold for a lower price.Leftward

shift in supply

Leftward shift in supply

Forms of Price Supports

3. Set-aside program: Requiring (or paying) farmers to take land out of production. Rarely effective because farmers set aside their least productive land and intensively produce in the more productive land thus increasing supply

Leftward shift in supply

4020 60

Effect of a Leftward shift in Supply

Price paid by consumers increases

Quantity decreases

Forms of Price Supports4. Purchase and Release: CCC buys grain at the

support price, stores it, and releases it back into the market if the market price rises to a prescribed trigger level of, say, 140 percent of the support price.

This policy protects growers against the risk of low prices but also protects consumers against unusually high prices.

Purchase and Release

Government purchase the surplus at $2

If the price in the market rises above $2

$2.5 S1

The government releases the surplus until the price is $2

Forms of Price Supports5. Loans: CCC gives farmers nine-month loans equal

to their production times the support price. The CCC accepts the grain as collateral for the loan. • If, during the term of the loan, the market price

rises above the support price, farmers repay the loan with interest and sell the grain in the market.

• If the market price remains at or below the loan rate, farmers forfeit the grain to the CCC, keep the money, and have no further obligation.

Loans to Farmers

If the price in the market falls below $2, the farmer forfeits the grain and does

not repay the loan

If the price in the market rises above $2, farmers sell their crop at the higher

price and repay the loan.

Government loan= Production(60) x $2(support

price)

Farmers compete against one another for limited amount of farmland, bidding up its price. Thus, it is the owners of farmland, and not farmers, who are the principal beneficiaries.

Price supports create a surplus.

The typical way for the price support agency to get rid of its inventories is to use export subsidies to make them cheaper for foreigners to buy. Is subsidizing foreign consumption a proper use of taxpayer money?

•The EC uses this approach for grains. From the mid seventies to early eighties, internal EC grain prices were 150 to 200 percent of the prices at which other countries were willing to buy their grain. Subsidies to agriculture account for over two-thirds of the total EC budget.

Effect of Price Supports

Figure 2

1. Equilibrium price is: ______ Equilibrium quantity is __________2. If the price is $100, there would be a (surplus/shortage)_________ of size__________3. Given your answer to #2 above, you expect the price to (increase/decrease/remain the same)

to _________4. Draw a supply and demand diagram showing the effect of an increase in incomes. Be sure to

label properly old and new values (P0, Q0, P1,Q1), show shortage/surplus and write your answer.

Practice

90 210 650

Calculate CS, PS, WL and the equivalent “tax/subsidy” resulting from a price ceiling placed at $6.

Practice

5 20 50

Calculate CS, PS, WL and the equivalent “tax/subsidy” resulting from a price floor placed at $20.

Practice

420200 650

1. Equilibrium price is: ______ Equilibrium quantity is __________

2. A $10 ceiling, would cause a (surplus/shortage)_________ of size__________

3. Calculate Consumer and Producer Surplus at equilibrium

Practice

1. Equilibrium price is: ______ Equilibrium quantity is __________2. A $20 floor, would cause a (surplus/shortage)_________ of

size__________3. Calculate Consumer and Producer Surplus at equilibrium

Practice

Another Look at Supply and Demand

Producers are willing to bring 500 units for sale if and only if the price per

unit is $60

Consumers are willing to buy 500 units if and only if

the price per unit is $60

Elasticity and Price Controls

• When supply and demand are both elastic, a price floor will cause a larger surplus than when supply and demand are inelastic

• When supply and demand are both elastic, a price ceiling will cause a a larger shortage than when supply and demand are inelastic.

The Effect of a Tax

Consumers and producers share the burden of a tax

The Effect of a Tax

Levied on the Producer

The Effect of a $10 Tax Paid by Producers

If the price is $60 per unit, producer would produce 500 units

After tax, producers receive only $50

At $50, producers would not bring 500 units for sale.

For producers to be willing to produce 500 units, the consumer must pay $70

Less than 500

The Effect of a $10 Tax Paid by Producers

The same would be true for all quantities…

Splus tax

The tax is equivalent to an increase

in cost.

After Tax Equilibrium Price

After the shift in supply, the new equilibrium price is higher than $60

New Equilibrium

Quantity

But is NOT $70!!

After the tax…

Swith tax

And pay a higher price: Pc

The government

receives t (tax per unit)

The producer

receives Pc- t

Consumers purchase fewer units

New Equilibrium

Quantity

A Producer TaxThe tax drives a

“wedge” between the price the buyer pays

and the price the seller receives

Welfare Loss From a Tax

Tax Revenue

Welfare Loss

Tax = $2 per unit

403020 5010 60 70 80

Impose a $2 tax on Producers

1. Shift Supply up by the amount of the tax

10t=$2

403020 5010 60

2. Find the new equilibrium price: Pc the price the consumer pays after the tax

10t=$2

403020 5010 60

3. Drop a line to the OLD supply curve: this represents subtracting the tax from the price the consumer pays, to get the price the producer receives

403020 5010 60

3. Ignore the Supply +tax line to determine CS, PS and Tax Revenue.

Tax Revenue

403020 5010 60

4. At equilibrium (before the tax) 40 units are produced.

Tax Revenue WL After the tax, only 30 units are produced:

Tax creates a Welfare Loss

403020 5010 60

CS=3*30*1/2

3*30*1/2= PS

Tax Rev=2*30

WL= 2*10*1/2

The Effect of a Tax

Levied on the Consumer

The same would be true for all quantities…

If the price is $60 consumers buy 500 unitsWith a $10 tax, the actual Price consumers pay to be willing to buy 500 units is $10 lower than before

The Effect of a $10 Tax Paid by Consumers

403020 5010 60 70 80

Impose a $2 tax on Consumers

1. Shift Demand down by the amount of the tax

403020 5010 60 70 80

2. Find the new equilibrium price: Pp Price the producer receives

after the tax

3. Draw a line up to the OLD demand curve: this represents adding the tax from the price the producer receives, to get the price the consumer pays

403020 5010 60

Tax RevenueTax

403020 5010 60

$2 tax on Producer

$2 tax on consumer

403020 5010 60

$2 tax on Producer

$2 tax on consumer

$4 tax on consumer

$4 tax on Producer

403020 5010 60

$2 tax on Producer

$2 tax on consumer

Regardless of Who Pays the Tax

Price Consumer

Price Producer Receives

As price Increases quantity demanded falls

As price drops quantity supplied falls

The Consumer

The Producer

Determining the Burden of The Tax

Regardless on who the tax is levied on, consumers and producers end up “sharing” the burden of the tax…

Consumers now pay $tc

more per unit.

Producers now receive $tp less per unit sold

The more Inelastic Demand is relative to Supply:

Larger the price increase to consumer

The smaller the price drop to producer

If Demand is more inelastic than Supply

The price the consumer pays after tax is $7 higherThe price the producer receives after tax is $3 lower

Clearly, the consumer bears a larger burden of the tax than the producer…

Extra cost to

consumer

Cost to producer

7 x 4907 x 490

3 x 4903 x 490

The more Inelastic Supply is relative to Demand:

Smaller the price increase to consumer

The larger the price drop to producer

A 70 unit decrease in quantity demanded, requires a “smaller” increase in priceA 70 unit decrease in quantity supplied, requires a “larger” decrease in price

500430

The price the consumer pays after tax is $3 higher

The price the producer receives after tax is $7 lower

Clearly, the producer bears a larger burden of the tax than the consumer…

500430

epd= %Qd/%P

At new equilibrium: quantity demanded and quantity supplied must both drop by the same amount: say 10%

Since the elasticity of demand is equal to the elasticity of supply say: 1.2

eps= %Qs/%P

8.3% increase

8.3% decrease55

10% decrease

-10%-10%

-1.2-1.2

When Demand and Supply have the Same Elasticity

The % change in price must also be the same.

When Demand and Supply have the Same Elasticity

The tax burden is equally shared…

Regardless of Who Pays the Tax

The Burden of the tax falls more heavily on the group with the lowest

elasticity

TAX ON INSURANCE

“If the government imposes a tax on insurance companies, the tax will be entirely passed on to consumers and insurance premiums will increase”

Is this true? When is this true?We need to know first if demand for health

insurance is more or less inelastic than supplyIf Demand is more inelastic is this true?

Would it help if the government

offers more alternatives for consumers to

purchase insurance?

If Demand is More Inelastic Than Supply…

Clearly, the consumer bears a larger burden of the tax than the producer…

The More Elastic Demand Is Relative to Supply

Price Consumer

The smaller the increase in price necessary to reduce the quantity demanded

The smaller the burden of the tax shared by the consumer

Percentage of the tax burden on Producer

Producer’s tax Share

Price Elasticity of Demand

Price elasticity of Supply + Price elasticity of Demand

X 100=

epd = 0.7 ep

s = 0.1

0.1 + 0.7 = 0.887.5%

The More Elastic Demand is Relative to Supply

Price Producer ReceivesPrice

Producer Receives

Price Producer Receives

The larger the drop in price necessary to reduce the quantity supplied

The larger the burden of the tax shared by the producer

Smaller the drop in quantity after

the tax is imposed

The smaller the welfare loss

Same size tax

Inelastic supply and

demand

Elastic

Larger the drop in quantity after the

tax is imposed

The larger the welfare loss

The larger the elasticity of demand and supply, the larger the welfare loss

The larger the tax revenueThe larger the tax revenue

Inelastic supply and

demand

Elastic

The larger the elasticity of demand and supply, the smaller the amount of tax revenue collected.

Tax RevenueSame size tax

Tax RevenueTax Revenue

The smaller the tax revenueThe smaller the tax revenue

Larger the drop in quantity after the tax is imposed

Smaller the drop in quantity after the tax is imposed

Percentage of the tax burden on Consumer

Consumer’s tax Share

Price Elasticity of Supply

Price elasticity of Supply + Price elasticity of Demand

X 100=

epd = 0.7 ep

s = 0.1

0.1 + 0.7 = 0.812.5%

Perfect Competition

Qe=4000

PRODUCER AND CONSUMER SURPLUS Colander 8 th ed Ch. 8 (179 – 180) Colander 9 th ed Ch. 7 Baumol Ch....

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