Problem
You have the following information about good
X and good Y:
Income elasticity of demand for good X: 3
Cross-price elasticity of demand for good X with respect to
the price of good Y: 2
Would an increase in income and a decrease in the price of
good Y unambiguously decrease the demand for good X? Why
or why not?
Solution
Yes, an increase in income would decrease the demand for
good X because the income elasticity is less than zero,
indicating that good X is an inferior good.
A decrease in the price of good Y will decrease the demand
for good X because the two goods are substitutes (as
indicated by a cross-price elasticity that is greater than
zero).
1
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Consumer and Producer
Surplus
Willingness to Pay (WTP)
A buyers willingness to pay for a good is the
maximum amount the buyer will pay for that good.
WTP measures how much the buyer values the good.
name
WTP
Anthony $250
Chad
175
Flea
300
John
125
Example:
4 buyers WTP
for an iPod
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WTP and the Demand Curve
Q: If price of iPod is $200, who will buy an iPod, and
what is quantity demanded?
A: Anthony & Flea will buy an
iPod, Chad & John will not.
name
WTP
Anthony $250
Chad
175
Flea
300
John
125
Hence, Qd = 2
when P = $200.
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WTP and the Demand Curve
Derive the
demand
schedule:
name
WTP
Anthony $250
Chad
175
Flea
300
John
125
P (price
of iPod)
$301 &
up
251
300
176
250
126
175
who buys
Qd
nobody
Flea
Anthony, Flea
Chad, Anthony,
Flea
John, Chad,
0 125
Anthony, Flea
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4
5
WTP and the Demand Curve
P
Q
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Qd
$301 & up
251 300
176 250
126 175
0 125
About the Staircase Shape
P
This D curve looks like a staircase
with 4 steps one per buyer.
If there were a huge # of
buyers, as in a competitive
market,
there would be a huge #
of very tiny steps,
and it would look
more like a
smooth curve.
Q
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WTP and the Demand Curve
P
Fleas
WTP
Anthonys
WTP
Chads WTP
Johns
WTP
At any Q,
the height of
the D curve is
the WTP of the
marginal buyer,
the buyer who
would leave the
market if P were
any higher.
Q
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Consumer Surplus (CS)
Consumer surplus is the amount a buyer is willing
to pay minus the amount the buyer actually pays:
CS = WTP P
name
WTP
Anthony $250
Chad
175
Flea
300
John
125
Suppose P = $260.
Fleas CS = $300 260 =
$40.
The others get no CS
because they do not buy an
iPod at this price.
Total CS = $40.
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CS and the Demand Curve
P
P = $260
Fleas
WTP
Fleas CS =
$300 260 =
$40
Total CS = $40
Q
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10
CS and the Demand Curve
P
Instead, suppose
Fleas
WTP
Anthonys
WTP
P = $220
Fleas CS =
$300 220 =
$80
Anthonys CS =
$250 220 =
$30
Total CS = $110
Q
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11
CS and the Demand Curve
P
The lesson:
Total CS equals
the area under
the demand
curve above the
price, from 0 to
Q.
Q
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12
CS with Lots of Buyers & a Smooth D Curve
At Q = 5(thousand),
Price
the marginal buyer
per pair
is willing to pay $50 $
for pair of shoes.
The demand for
shoes
Suppose P = $30.
Then his consumer
surplus = $20.
1000s of
pairs of
shoes
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Q
13
CS with Lots of Buyers & a Smooth D Curve
CS is the area b/w
P and the D curve,
from 0 to Q.
Recall: area of
a triangle equals
x base x height
P
$
The demand for
shoes
Height =
$60 30 = $30.
So,
CS = x 15 x $30
= $225.
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Q
14
How a Higher Price Reduces CS
If P rises to $40,
CS = x 10 x $20
= $100.
Two reasons for the
fall in CS.
2. Fall in CS due
to remaining
buyers
paying higher
P
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1. Fall in CS
due to
buyers
leaving
market
Q
15
Consumer surplus
A. Find CS for
P = $30.
demand curve
Suppose P falls to $20.
How much will CS
increase due to
B. buyers entering
the market
C. existing buyers
paying lower price
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Rights Reserved.
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except
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use.
16
Answers
A. CS = x 10 x $10
= $50
demand curve
P falls to $20.
B. CS for the
additional buyers
= x 10 x $10 = $50
C. Increase in CS
on initial 10 units
= 10 x $10 = $100
2013
Cengage
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AllReserved.
Rights Reserved.
May notMay
be copied,
not be copied,
scanned,scanned,
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in part,
or in
except
part,for
except
use as
for use as
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permitted
in a license
in a distributed
license distributed
with a certain
with a certain
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for classroom
use.
use.
17
Importance of Consumers Surplus:
Consumer surplus is a measure of the welfare that people gain from
consuming goods and services
In Public Finance:
It is useful to a Finance Minister in imposing taxes and fixing their rates.
He will tax those commodities in which the consumers enjoy much
surplus
To the Businessman and Monopolist:
To the businessman also the concept is very useful. He can raise prices
of those articles in which there is a large consumers surplus.
Comparison of economic condition:
We can compare the economic condition of nation by the help of concept
of consumer surplus.
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18
PROBLEM
Melissa buys an iPod for $100 and gets consumer surplus of $80.
a. What is her willingness to pay?
b. If she had bought the iPod on sale for $70, what would her
consumer surplus have been?
c. If the price of an iPod were $200, what would her consumer
surplus have been?
Solution
a. Consumer surplus is willingness to pay minus the price paid. Therefore,
willingness to pay is the sum of consumer surplus and the price paid, or
$100 + $80 = $180.
b. Her surplus is willingness to pay minus the price paid or $180 - $70 =
$110.
c. Because $200 exceeds her willingness to pay, she does not purchase an
iPod and she receives no consumer surplus
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19
Cost and the Supply Curve
Cost is the value of everything a seller must give
up to produce a good (i.e., opportunity cost).
Includes cost of all resources used to produce
good, including value of the sellers time.
Example: Costs of 3 sellers in the lawn-cutting
business.
A seller will produce and sell
name cost
the good/service only if the
Jack
$10
price exceeds his or her cost.
Janet
20
Hence, cost is a measure of
Chrissy
35
willingness to sell.
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20
Cost and the Supply Curve
Derive the supply schedule
from the cost data:
name
cost
Jack
$10
Janet
20
Chrissy
35
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Qs
$0 9
10 19
20 34
35 & up
21
Cost and the Supply Curve
P
P
Qs
$0 9
10 19
20 34
35 & up
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22
Cost and the Supply Curve
P
Chrissys
cost
Janets
cost
Jacks cost
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At each Q,
the height of
the S curve
is the cost of the
marginal seller,
the seller who
would leave
the market if
the price were
any lower.
23
Producer Surplus
P
PS = P cost
Producer surplus (PS):
the amount a seller
is paid for a good
minus the sellers cost
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24
Producer Surplus and the S
Curve
P
PS = P cost
Chrissys
cost
Janets
cost
Jacks PS = $15
Janets PS = $5
Chrissys PS = $0
Total PS = $20
Jacks cost
Suppose P = $25.
Total PS equals the
area above the supply
curve under the price,
from 0 to Q.
25
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PS with Lots of Sellers & a Smooth S Curve
Suppose P = $40.
Price
per pair
At Q = 15(thousand),
the marginal sellers
cost is $30,
The supply of shoes
and her producer
surplus is $10.
1000s of pairs
of shoes
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26
PS with Lots of Sellers & a Smooth S Curve
PS is the area b/w
P and the S curve,
from 0 to Q.
The supply of shoes
The height of this
triangle is
$40 15 = $25.
So,
PS = x b x h
= x 25 x $25
= $312.50
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Q
27
How a Lower Price Reduces PS
If P falls to $30,
PS = x 15 x $15
= $112.50
1. Fall in PS
due to sellers
leaving market
Two reasons for
the fall in PS.
2. Fall in PS due to
remaining sellers
getting lower P
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Q
28
Producer surplus
A. Find total PS for
P = $20.
supply curve
Suppose P rises to $30.
Find the increase
in PS due to:
B. selling 5
additional units
C. getting a higher price
on the initial 10 units
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Rights Reserved.
May notMay
be copied,
not be copied,
scanned,scanned,
or duplicated,
or duplicated,
in wholeinorwhole
in part,
or in
except
part,for
except
use as
for use as
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in a license
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with a certain
with a certain
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or service
or service
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or otherwise
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use.
29
Answers
A. PS = x 10 x $20
= $100
supply curve
P rises to $30.
B. PS on
additional units
= x 5 x $10 = $25
C. Increase in PS
on initial 10 units
= 10 x $10 = $100
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30
PROBLEM
Ernie owns a water pump. Because pumping large amounts of water is
harder than pumping small amounts, the cost of producing a bottle of water
rises as he pumps more. Here is the cost he incurs to produce each bottle
of water:
Cost of first bottle $1
Cost of second bottle 3
Cost of third bottle 5
Cost of fourth bottle 7
a. From this information, derive Ernies supply schedule. Graph his supply
curve for bottled water.
b. If the price of a bottle of water is $4, how many bottles does Ernie
produce and sell? How much producer surplus does Ernie get from these
sales? Show Ernies producer surplus in your graph.
c. If the price rises to $6, how does quantity supplied change? How does
Ernies producer
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31
b. Ernies total producer surplus is $3 + $1
= $4, which is the area of A in the figure
c. He gets producer surplus of $5 from the
first bottle ($6 price minus $1 cost), $3 from
the second bottle ($6 price minus $3 cost),
and $1 from the third bottle ($6 price minus
$5 price), for a total producer surplus of $9.
(both areas A and B )
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32
CS, PS, and Total Surplus
CS = (value to buyers) (amount paid by buyers)
= buyers gains from participating in the
market
PS = (amount received by sellers) (cost to sellers)
= sellers gains from participating in the market
Total surplus = CS + PS
= total gains from trade in a market
= (value to buyers) (cost to sellers)
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33
The Markets Allocation of
Resources
In a market economy, the allocation of resources
is decentralized, determined by the interactions
of many self-interested buyers and sellers.
We use total surplus as a measure of societys
well-being, and we consider whether the markets
allocation is efficient.
(Policymakers also care about equality, though
our focus here is on efficiency.)
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34
Efficiency
Total = (value to buyers) (cost to sellers)
surplus
An allocation of resources is efficient if it maximizes
total surplus. Efficiency means:
The goods are consumed by the buyers who
value them most highly.
The goods are produced by the producers with the
lowest costs.
Raising or lowering the quantity of a good
would not increase total surplus.
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35
Evaluating the Market Equilibrium
Market eqm:
P = $30
Q = 15,000
Total surplus
= CS + PS
Is the market eqm
efficient?
P
S
CS
PS
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Q
36
Does Eqm Q Maximize Total Surplus?
The market
eqm quantity
maximizes
total surplus:
At any other
quantity,
can increase
total surplus by
moving toward
the market eqm
quantity.
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Q
37
PROBLEM
There are four consumers willing to pay the following amounts for haircuts:
Jerry: $7 Oprah: $2 Ellen: $8 Phil: $5
There are four haircutting businesses with the following costs:
Firm A: $3 Firm B: $6 Firm C: $4 Firm D: $2
Each firm has the capacity to produce only one haircut. For efficiency, how
many haircuts should be given?
Which businesses should cut hair and which consumers should have their
hair cut?
How large is the maximum possible total surplus?
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38
Solution
Supply equals demand at a quantity of three haircuts and a price between
$4 and $5. Firms A, C, and D should cut the hair of Ellen, Jerry, and Phil.
Oprahs willingness to pay is too low and firm Bs costs are too high, so
they do not participate. The maximum total surplus is the area between the
demand and supply curves, which totals $11 ($8 value minus $2 cost for
the first haircut, plus $7 value minus $3 cost for the second, plus $5 value
minus $4 cost for the third).
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39
