THIRD EDITION
ECONOMICS
and
MICROECONOMICS
>> Paul Krugman | Robin Wells
Chapter 4
Consumer and Producer Surplus
©2011 Worth Publishers
• What consumer surplus is and its
relationship to the demand curve
• What producer surplus is and its
relationship to the supply curve
WHAT YOU • What total surplus is and how it can be
WILL LEARN used both to measure the gains from
trade and to illustrate why markets work
IN THIS
so well
CHAPTER • Why property rights and prices as
economic signals are critical to smooth
functioning of a market
• Why markets typically lead to efficient
outcomes despite the fact that they
sometimes fail
Consumer Surplus and the Demand Curve
A consumer’s willingness to pay for a good is the maximum
price at which he or she would buy that good.
Individual consumer surplus is the net gain to an individual
buyer from the purchase of a good.
It is equal to the difference between the buyer’s willingness
to pay and the price paid.
The Demand Curve for Used Textbooks
Price of
book
$59 Aleisha Potential Willingness
buyers to pay
Aleisha $59
45 Brad Brad 45
Claudia 35
35 Claudia Darren 25
Edwina 10
25 Darren
A consumer’s willingness to
pay for a good is the
10 Edwina
maximum price at which he
or she would buy that good.
D
0 1 2 3 4 5
Quantity of books
Willingness to Pay and Consumer Surplus
Total consumer surplus is the sum of the individual
consumer surpluses of all the buyers of a good.
The term consumer surplus is often used to refer to both
individual and total consumer surplus.
Consumer Surplus in the Used Textbook Market
Price of
book Aleisha’s consumer surplus:
$59 − $39 = $29
$59 Aleisha
Brad’s consumer surplus: The total consumer surplus
$45 − $30 = $15 is given by the entire
shaded area —
45 Brad
Claudia’s consumer the sum of the individual
surplus: $35 − $30 = $5
consumer surpluses of
35 Claudia Aleisha, Brad, and Claudia
30 Price = $30 — equal to
25 Darren $29 + $15 + $5 = $49.
10 Edwina
D
0 1 2 3 4 5 Quantity of books
Consumer Surplus in the Used Textbook Market
Consumer Surplus
The total consumer surplus
Price of
iPad
generated by purchases of a
good at a given price is equal
to the area below the demand
curve but above that price.
Consumer
surplus
$500 Price = $500
0 1 million
Quantity of iPads
How Changing Prices Affect Consumer Surplus
A fall in the price of a good increases consumer surplus
through two channels:
1. a gain to consumers who would have bought at the
original price
2. a gain to consumers who are persuaded to buy by the
lower price
Consumer Surplus and a Fall in the Price of Used Textbooks
Price of
book
Increase in
$59 Aleisha’s
Aleisha consumer surplus
Increase in Brad’s
consumer surplus
45 Brad
Increase in Claude’s
35 Claudia consumer surplus
30 Original price = $30
25 Darren
20 New price = $20
Darren’s
10 Edwina consumer
surplus
D
0 1 2 3 4 5
Quantity of books
A Fall in the Market Price Increases Consumer Surplus
Price of iPad
Increase in consumer
surplus to original buyers
$2,000
Consumer surplus
gained by new
buyers
500
0 200,000 1 million Quantity of iPads
FOR INQUIRING MINDS
A Matter of Life and Death
Each year, about 4,000 people in the United States die while
waiting for a kidney transplant.
According to the current United Network for Organ Sharing
(UNOS) guidelines, a donated kidney goes to the person
who has waited the longest regardless of their age.
FOR INQUIRING MINDS
A Matter of Life and Death
The UNOS is now devising a new set of guidelines where
kidneys would be allocated on the basis of who will receive
the greatest net benefit, where net benefit is measured as
the increase in lifespan from the transplant.
This would increase the recipients’ extra years by 11,000.
The “net benefit” concept is like consumer surplus: the
individual consumer surplus generated from getting a new
kidney.
ECONOMICS IN ACTION
When Money Isn’t Enough
The key insight we get from the concept of consumer
surplus is that purchases yield a net benefit to the
consumer. The consumer typically pays a price less than
his or her willingness to pay.
Most of the time we don’t think about the value associated
with the right to buy a good.
ECONOMICS IN ACTION
When Money Isn’t Enough
During World War II, governments in many countries
created a system of rationing goods where coupons gave
individuals the right to buy goods at the government-
regulated price.
As a result, illegal markets in meat stamps and gas coupons
emerged. Also, criminals began stealing and counterfeiting
coupons.
People who bought ration coupons on the illegal market
were paying for the right to get some consumer surplus.
Producer Surplus and the Supply Curve
A potential seller’s cost is the lowest price at which he or
she is willing to sell a good.
Individual producer surplus is the net gain to a seller from
selling a good. It is equal to the difference between the
price received and the seller’s cost.
Total producer surplus in a market is the sum of the
individual producer surpluses of all the sellers of a good.
The Supply Curve for Used Textbooks
Price of
book
Potential
S sellers Cost
Engelbert $5
$45 Engelbert
Donna 15
Carlos 25
35 Donna
Betty 35
Andrew 45
25 Carlos
15 Betty
5 Andrew
0 1 2 3 4 5 Quantity of books
Producer Surplus in the Used Textbook Market
Price of book
$45
Engelbert
35 Donna
30 Price = $30
25 Carlos’s
Carlos producer
surplus
15 Betty Betty’s
producer
Andrew’s surplus
5 Andrew producer
surplus
0 1 2 3 4 5
Quantity of books
Producer Surplus
The total producer
surplus from sales of a
Price of wheat (per bushel)
good at a given price is
S
the area above the
supply curve but below
that price.
$5 Price = $5
Producer
surplus
0 1 million
Quantity of wheat (bushels)
Changes in Producer Surplus
When the price of a good rises, producer surplus increases
through two channels:
1. the gains of those who would have supplied the good
even at the original, lower price
2. the gains of those who are induced to supply the good
by the higher price
A Rise in the Price Increases Producer Surplus
Price of wheat (per
bushel)
Increase in producer Producer
surplus to original surplus gained S
sellers by new sellers
$7 New price = $7
5 Original price = $5
0 1 million 1.5 million
Quantity of wheat (bushels)
ECONOMICS IN ACTION
High Times Down on the Farm
The government encouraged the use of gasoline that
contains a percentage of ethanol in order to fight air
pollution and to reduce U.S. dependence on foreign oil.
The average value of farmland in Iowa hit a record high in
2010.
ECONOMICS IN ACTION
High Times Down on the Farm
One result of the shift to ethanol fuel has been a rise in
the demand for corn, leading to a surge in corn prices. In
2010, the price of corn jumped by 52%.
A person who buys a farm in Iowa buys the producer
surplus that farm generates. Higher prices for corn, which
raised the producer surplus of Iowa farmers, made Iowa
farmland more valuable.
ECONOMICS IN ACTION
Putting It Together: Total Surplus
The total surplus generated in a market is the total net gain
to consumers and producers from trading in the market. It
is the sum of the producer and the consumer surplus.
The concepts of consumer surplus and producer surplus
can help us understand why markets are an effective way to
organize economic activity.
Total Surplus
Price of book
Consumer
Equilibrium surplus E
price $30
Producer
surplus
0 1,000 Quantity of books
Equilibrium quantity
Consumer Surplus, Producer Surplus, and the Gains from Trade
The previous graph shows that both consumers and
producers are better off because there is a market in this
good; i.e., there are gains from trade.
These gains from trade are the reason everyone is better off
participating in a market economy than they would be if
each individual tried to be self-sufficient.
But are we as well off as we could be? This brings us to the
question of the efficiency of markets.
The Efficiency of Markets: A Preliminary View
Claim: The maximum possible total surplus is achieved at
market equilibrium.
The market equilibrium allocates the consumption of the
good among potential consumers and sales of the good
among potential sellers in a way that achieves the highest
possible gain to society.
By comparing the total surplus generated by the
consumption and production choices in the market
equilibrium to the surplus generated by a different set of
production and consumption choices, we can show that any
change from the market equilibrium reduces total surplus.
Three ways in which you might try to increase the total surplus
1. Reallocate consumption among consumers—take the good
away from buyers who would have purchased the good in
the market equilibrium, and give it to potential consumers
who wouldn’t have bought it in equilibrium
2. Reallocate sales among sellers—take sales away from
sellers who would have sold the good in the market
equilibrium, and instead compel potential sellers who
would not have sold the good in equilibrium to sell it
3. Change the quantity traded—compel consumers and
producers to transact either more or less than the
equilibrium quantity
Reallocating Consumption Lowers Consumer Surplus
Price of book
Loss in consumer
surplus if the book is S
taken from Ana and
given to Bob
A
$35
E
30
B
25
0 1,000 Quantity of books
Reallocating Sales Lowers Producer Surplus
Price of book
Y
$35
E Loss in producer surplus if
30 Yvonne is made to sell the
book instead of Xavier
X
25
0 1,000 Quantity of books
Changing the Quantity Lowers Total Surplus
Price of book
Loss in total surplus if
the transaction S
between Ana and
Xavier is prevented
A Y
$35
Loss in total surplus if the
E transaction between
30
Yvonne and Bob is forced
25
X B
0 1,000
Quantity of books
ECONOMICS IN ACTION
eBay and Efficiency
Garage sales are an old American tradition: they are a way
for people to sell items they don’t want to others who have
some use for them, to benefit both parties.
However, many potential beneficial trades are missed
because sellers and buyers may not be in position to meet
one another because factors such as distance.
ECONOMICS IN ACTION
eBay and Efficiency
eBay provides a way for would-be buyers and would-be
sellers of unique or used items to find one another even if
they don’t live in the same neighborhood or city.
The potential gains from trade were evidently large: in
2010, eBay reported $53.5 billion in goods were bought and
sold on its websites.
ECONOMICS IN ACTION
Take the Keys, Please
A Boston couple used the online matching website
RelayRides to rent out their car that had been sitting
around largely unused, earning enough to pay for its
upkeep and insurance.
The founder of RelayRides, Shelby Clark, reports that the
average car renter on his website earns $250 per month.
RelayRides and online matching companies like it are
becoming more popular by helping individuals generate a
little bit more surplus from their possessions.
ECONOMICS IN ACTION
Market Equilibrium Maximizes Total Surplus
1. Market equilibrium allocates consumption of the good to
the potential buyers who value it the most, as indicated by
the fact that they have the highest willingness to pay.
2. It allocates sales to the potential sellers who most value the
right to sell the good, as indicated by the fact that they have
the lowest cost.
Market Equilibrium Maximizes Total Surplus
3. It ensures that every consumer who makes a purchase
values the good more than every seller who makes a sale, so
that all transactions are mutually beneficial.
4. It ensures that every potential buyer who doesn’t make a
purchase values the good less than every potential seller
who doesn’t make a sale, so that no mutually beneficial
transactions are missed.
Market Equilibrium Maximizes Total Surplus
• As a result of these four functions, any way of allocating
the good other than the market equilibrium outcome
lowers total surplus.
Three Caveats
• First, although a market may be efficient, it isn’t necessarily
fair. In fact, fairness, or equity, is often in conflict with
efficiency. Because society cares about equity, government
intervention in a market that reduces efficiency while
increasing equity can be justified.
• The second caveat is that markets sometimes fail. Under
some well-defined conditions, markets can fail to deliver
efficiency. When this occurs, markets no longer maximize
total surplus.
Three Caveats
• Third, even when the market equilibrium maximizes total
surplus, this does not mean that it results in the best
outcome for every individual consumer and producer.
For instance, a price floor that kept the price up would
benefit some sellers.
But in the market equilibrium there is no way to make
some people better off without making others worse off
— and that’s the definition of efficiency.
Why Markets Typically Work So Well
Economists have written volumes about why markets are an
effective way to organize an economy. In the end, well-
functioning markets owe their effectiveness to two powerful
features: property rights and the role of prices as economic
signals.
Property rights are the rights of owners of valuable
items, whether resources or goods, to dispose of those
items as they choose.
An economic signal is any piece of information that
helps people make better economic decisions.
A Few Words of Caution
• A market or an economy is inefficient if there are missed
opportunities: some people could be made better off
without making other people worse off.
• The three principal sources of market failure are:
1. attempts to capture more resources that produce
inefficiencies,
2. side effects from certain transactions, and
3. problems in the nature of the goods themselves.
ECONOMICS IN ACTION
A Great Leap — Backward
Economies in which a central planner, rather than markets,
makes consumption and production decisions are known as
planned economies.
Examples: Russia and many Eastern European countries
Planned economies are notorious for their inefficiency, and
what is probably the most compelling example is the so-
called Great Leap Forward which was instituted in China in
the late 1950s by Mao Zedong.
ECONOMICS IN ACTION
A Great Leap — Backward
Its intention was to speed up the country’s industrialization
by shifting from urban to rural manufacturing: farming
villages were supposed to start producing heavy industrial
goods such as steel.
The plan backfired as food production fell and at the same
time, industrial output declined because of inexperienced
rural producers.
The results were catastrophic as the following famine
reduced China’s population by 30 million.
NEWS: From The Economist
• E pluribus tunum: Uniform prices for online music are no
way to maximize profit:
[Link]
SUMMARY
1. The willingness to pay of each individual consumer
determines the demand curve.
When price is less than or equal to the willingness to pay,
the potential consumer purchases the good.
The difference between willingness to pay and price is the
net gain to the consumer, the individual consumer surplus.
2. Total consumer surplus in a market, the sum of all
individual consumer surpluses in a market.
A rise in the price of a good reduces consumer surplus; a
fall in the price increases consumer surplus.
SUMMARY
3. The cost of each potential producer, the lowest price at
which he or she is willing to supply a unit of that good,
determines the supply curve.
If the price of a good is above a producer’s cost, a sale
generates a net gain to the producer, known as the
individual producer surplus.
4. Total producer surplus in a market, the sum of the
individual producer surpluses in a market, is equal to the
area above the market supply curve but below the price.
SUMMARY
5. Total surplus, the total gain to society from the production
and consumption of a good, is the sum of consumer and
producer surplus.
6. Usually, markets are efficient and achieve the maximum
total surplus.
Any possible reallocation of consumption or sales, or a
change in the quantity bought and sold, reduces total
surplus.
However, society also cares about equity. So government
intervention in a market that reduces efficiency but
increases equity can be a valid choice by society.
SUMMARY
7. An economy composed of efficient markets is also
efficient, although this is virtually impossible to achieve in
reality.
The keys to the efficiency of a market economy are
property rights and the operation of prices as economic
signals.
Under certain conditions, market failure occurs, making a
market inefficient.
Three principal sources of market failure are attempts to
capture more surplus that create inefficiencies, side
effects of some transactions, and problems in the nature
of the good.
KEY TERMS
Willingness to pay Economic signal
Individual consumer Inefficient
surplus Market failure
Total consumer surplus
Consumer surplus
Cost
Individual producer surplus
Total producer surplus
Producer surplus
Total surplus
Property rights
