Managerial Economics

Executive MBA Program

Session 5: Consumer Surplus,
Producer Surplus and Market
Efficiency
Instructor
Sandeep Basnyat
9841892281
Sandeep_basnyat@yahoo.com

Welfare Economics

Welfare economics is the study of how

the allocation of resources affects

economic well-being.
Buyers and sellers receive benefits
from taking part in the market.
Consumer surplus measures economic
welfare from the buyers side.
Producer surplus measures economic
welfare from the sellers side.

The equilibrium in a market maximizes

the total welfare of buyers and sellers.

CONSUMER SURPLUS
Willingness to pay is the maximum
amount that a buyer will pay for a
good.
It measures how much the buyer
values the good or service.
Consumer surplus is the buyers
willingness to pay for a good minus
the amount the buyer actually pays for
it.
Its the benefit that buyers receive

WTP and the Demand Curve

Derive the
demand
schedule:

P (price
of iPod)

who buys

Qd

$301 & up nobody

251 300 Flea

Anthony $250

176 250 Anthony, Flea

Chad

175

Flea

300

Chad, Anthony,
126 175
Flea
John, Chad,
0 125
Anthony, Flea

name

John

WTP

125

WTP and the Staircase shaped Demand

Curve
P

$350
$300

Qd

$250
$200

$301 & up

251 300

$150

176 250

$100
$50

126 175

0 125

$0

WTP and the Staircase Demand Curve

P

Fleas WTP

$350
$300

Anthonys WTP

$250
$200

Chads WTP
Johns
WTP

$150
$100
$50
$0

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.

Mathematical Calculation of Consumer Surplus

(CS)
Consumer surplus is the amount a buyer is willing
to pay minus the buyer actually pays:

CS = WTP P
name

WTP

Anthony $250

Suppose P = $260.
Fleas CS = $300 260 = $40.

Chad

175

Flea

300

The others get no CS because

they do not buy an iPod at this
price.

John

125

Total CS = $40.

CS and the Demand Curve

P

P = $260

Fleas WTP

$350
$300

Fleas CS =
$300 260 = $40

$250
$200

Total CS = $40

$150
$100
$50
$0

CS and the Demand Curve

P

Fleas WTP

$350
$300

Anthonys WTP

$250
$200

Instead, suppose
P = $220
Fleas CS =
$300 220 = $80

Anthonys CS =
$250 220 = $30

$150

Total CS = $110

$100
$50
$0

Lessons from CS and the Demand Curve

P
The lesson:
Total CS equals
the area under
the demand curve
above the price,
from 0 to Q.

$350
$300
$250
$200
$150
$100
$50
$0

Further Calculations of CS with Smooth D

Curve
CS is the area b/w
P
P and the D
$ 60
curve, from 0 to
Q.
50
Recall: area of
h
40
a triangle equals
x base x height
30
Height of
20
this triangle is
$60 30 = $30.
10
So,
0
CS = x 15 x
$30
0
= $225.

The demand for shoes

D
Q
5 10 15 20 25 30

How a Higher Price Reduces CS

If P rises to $40,
CS = x 10 x $20
= $100.

Two reasons for

the fall in CS.

P
60
50

1. Fall in CS
due to buyers
leaving market

40
30

2. Fall in CS due to
remaining buyers
paying higher P

20
10

D
Q

0
0

5 10 15 20 25 30

PRODUCER SURPLUS
Producer surplus is the amount a
seller is paid for a good minus the
sellers cost.
It measures the benefit to sellers
participating in a market.
Its the benefit that producers receive
from their own perspective.

Cost and the Supply Curve

Derive the supply schedule

from the cost data:

name

cost

Angelo

$10

Hunter

20

Kitty

35

Qs

$0 9

10 19

20 34

35 & up

Cost and the Supply Curve

P

$40
$30
$20
$10
$0

Qs

$0 9

10 19

20 34

35 & up

Cost and the Supply Curve

P

$40

Kittys
cost

$30
$20

Hunters
cost

$10

Angelos cost

$0

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.

Producer Surplus
PS = P cost

$40

Producer surplus (PS):

the amount a seller
is paid for a good
minus the sellers cost.

$30
$20
$10
$0

Producer Surplus and the S Curve

PS = P cost

$40

Kittys
cost

$30
$20

Hunters
cost

$10

Angelos cost

$0

Suppose P = $25.
Angelos PS = $15
Hunters PS = $5
Kittys PS = $0

Total PS = $20
Total PS equals the
area above the supply
curve under the price,
from 0 to Q.

PS with Lots of Sellers & a Smooth S Curve

PS is the area b/w
P
P and the S curve,
60
from 0 to Q.
The height of this 50

triangle is
$40 15 = $25.

The supply of shoes

40
30
h
20

So,
PS = x b x h
= x 25 x $25 10
= $312.5
0

Q
0

5 10 15 20 25 30

How a Lower Price Reduces PS

If P falls to $30,
PS = x 15 x
$15
= $112.5

P
60
50

1. Fall in PS
due to sellers
leaving market

40

Two reasons for

30
the fall in PS.
2. Fall in PS due to
remaining sellers
getting lower P

20
10

0
0

5 10 15 20 25 30

Total Surplus
Total surplus
= Consumer surplus + Producer surplus
= Value to buyers Amount paid by buyers +
Amount received by sellers Cost to sellers
Total surplus = Value to buyers Cost to
sellers

Represents the entire area between the

maximum price that buyers want to pay and
the lowest cost that sellers would incur.

Evaluating the Market

Equilibrium
Market eqm:
P = $30
Q = 15,000
Total surplus
= CS + PS

P
60

50
40

CS

30

PS

20
10

D
Q

0
0

5 10 15 20 25 30

Market Efficiency
Market is considered efficient if it maximizes
the total surplus
Maximizing total surplus:
Maximizing consumer surplus by involving
maximum number of consumers in the
market for trade
+
Maximizing producer surplus by involving
maximum number of producers in the market
for trade

Does Eqm Q Maximize Total Surplus?

At Q = 10,
P
consumers
wants to pay as much 60
as $40 for the goods 50
and
40
cost of producing
the marginal unit
30
is $25
20
Since there is an
10
excess demand
sellers will be able to
0
increase total surplus
0
by producing more.

D
Q
5 10 15 20 25 30

Does Eqm Q Maximize Total Surplus?

At Q = 20,
cost of producing
the marginal unit
is $35
But consumers
wants to pay only
$20.

P
60

50
40
30

Since there is an
20
excess supply, some
sellers will not be able 10
to sell, causing total
0
surplus to decrease.

D
Q
0

5 10 15 20 25 30

Numerical Problems
Consider a market with demand curve q = 500
20p and supply curve q = - 50 + 25p. Here
q is in million kilograms per day and p is in
rupees per kilogram.
1) Determine the market equilibrium price and
quantity and the total revenue in this market.

(Ans. : P = Rs.12.22/Kg;
Q = 255.6 million kg;
TR = Rs. 3123.43 per day)

Numerical Problems
Consider a market with demand curve q = 500
20p and supply curve q = - 50 + 25p. Here
q is in million kilograms per day and p is in
rupees per kilogram.
2) Find consumer and producer surpluses in this
market. (Hint: to find maximum price that consumer
pays and minimum cost price of suppliers, put Q = 0 in
each functions)
(Ans.
:

Consumer Surplus = Rs. 1633.28

Producer surplus = Rs. 1306.12

1633.28
1306.12

Numerical Problems
Consider a market with demand curve q = 500
20p and supply curve q = - 50 + 25p. Here
q is in million kilograms per day and p is in
rupees per kilogram.
3) Calculate price elasticity of demand and price
elasticity of supply for this market.

(Ans. :
PED = - 0.96
PES = 1.19

Effect of Tax on Consumer and

Producer surplus

Surplus before the tax is

imposed
P
60

50
40

CS

30

PS

20
10

D
Q

0
0

5 10 15 20 25 30

Surplus after the tax is imposed

P
60

CS

50

Govt. Revenue

Bp
40
Tax

30
Sp
20
10

PS

0
0

Q
5 10 15 20 25 30

Tax Effect and Consumer and Producer Surplus

Price

Supply

CS

Price buyers
pay

Size of tax (T)

Tax
revenue
(T Q)
Price sellers
receive

PS

Demand

Quantity
sold (Q)
0

Quantity
with tax

Quantity
without tax

Quantity

Numerical Problems
Consider a market with demand curve q = 500
20p and supply curve q = - 50 + 25p. Here
q is in million kilograms per day and p is in
rupees per kilogram.
4) Imagine that the government imposes a Rs.2
per-unit tax on the buyers. Find the new market
equilibrium price and quantity. How much of the
tax burden is borne by the buyers, and how
much by the sellers?
(Ans. :
P = Rs. 11.33/kg/day; Q = 233.4 m Kgs.
Buyers Tax burden = Rs. 1.11/kg
Sellers tax burden = Rs. 0.89/kg

Numerical Problems
Consider a market with demand curve q = 500
20p and supply curve q = - 50 + 25p. Here
q is in million kilograms per day and p is in
rupees per kilogram.
5) Find the change in consumer and producer
surpluses in this market after the govt. impose
Rs. 2 per unit tax on buyers.
(Ans. :
Change in C.S. = Rs. 271.39
Change in P. S. = Rs. 217.31

Numerical Problems
6) Now imagine that the government instead
decides to impose a Rs.2 per-unit tax on the
sellers. Find the new market equilibrium price
and quantity. Calculate the change in consumer
and producer surpluses in this market.

(Ans. :
P = Rs.13.33/kg/day
Q = 233.4 m kg.
Change in C.S. = Rs. 271.39
Change in P. S. = Rs. 217.31

Numerical Problems
7) Now imagine that the government instead
decides to impose a sales tax of 20% on the
sellers. Find the new market equilibrium price
and quantity. Tax burdens on buyers and
sellers and calculate the change in consumer
and producer surpluses in this market.
(Ans. :
P = Rs.13.75/kg/day
Q = 225 m kg.
Buyers tax burden = Rs. 1.53/kg
Sellers tax burden = Rs. 1.22/kg
Change in C.S. = Rs. 367.65
Change in P. S. = Rs. 293.62

Thank you