Consumer and Producer

Surplus

In an un-regulated market, buyers and sellers buy and sell at the

prevailing market price. But, for some consumers the value of the good
exceeds this market price. Consumer surplus is equal to the shaded
area between market price and demand curve (Fig. 8.1).
Producers too enjoy a benefit i.e. the difference between the market
price the producers receives and the marginal cost of producing this
unit. Producer surplus is equal to the shaded area between the market
price and shaded area (Fig. 8.1)
Consumer surplus measures the total net benefit to consumers, and
thereby measure the gain or loss to consumers from a government
intervention
Producer surplus measures the total net benefit to producers, and
thereby measure the gain or loss to producers from a government
intervention
Application of Consumer and Producer Surplus
With government intervention, the price gets reduced as well as
production. This results in excess demand
Change in consumer surplus: The net change in consumer surplus is
equal to A B (Fig. 8.2.The rectangle A is larger than triangle B,
therefore net change in consumer surplus is positive
Change in Producer Surplus: With price controls, some producers will
stay in the market but will receive a lower price for their output, while
other producers will leave the market. The triangle C is the additional
loss for those producers who have left the market and those who have
stayed but are producing less. Therefore, the total loss is A C
Deadweight Loss: The loss to producers is much more than the gain to
consumers (Fig8.2). This is known as deadweight loss. The change in
consumer surplus is A B and the change in producer surplus is -A C.
The total change in surplus is therefore (A B)+ (- A C)= - B C,
which is given by the two triangles B and C. The deadweight loss
reflects an inefficiency caused by price controls, the loss in producer
surplus exceeds the gain in consumer gain. ( Example. 9.1, Oil price
controls leading to gasoline shortages)
The Efficiency of a Competitive Market:

Economic efficiency implies the maximization of aggregate consumer

and producer surplus. A deadweight loss does not always mean that a
policy is bad, it may fulfill other important objectives.
Market Failure: market failure occurs when prices fail to provide the
signals to consumers and producers. The unregulated competitive
market is inefficient because it does not maximise aggregate consumer
and producer surplus
Externalities- externalities are costs and benefits that do not show up
as part of the market price (e.g. cost to society of environmental
pollution)
Lack of Information: market failure can also occur when consumers
lack information about the quality or nature of a product, and therefore
cannot
make
utility-maximizing
purchasing
decisions.
Govt.
intervention in the form of labeling may correct the failure
In the absence of externalities or lack of information, an unregulated
competitive market does lead to the economically efficient output level
In Fig. 8.5, the price P2 is fixed above the market clearing price Po. At
a higher price, Q3 will be demanded and hence consumer loss is equal
to b and producer loss is equal to C. The total deadweight loss B and C
gives an optimistic assessment of the efficiency cost of policies that
force price above market clearing levels
Minimum Price
Government policies sometimes seeks to raise prices above marketclearing levels, rather than lower them (minimum wage law, resulting
in unemployment Fig.8.8).Government intervention in the form of
minimum price can reduce producers profits because of the cost of
excess production Q2 Q3 in Fig. 8.7)
Price Support and Production Quotas
The Government sets the market price of a good above the free-market
level and buys up whatever output is needed to maintain that price.
The Government can also increase price restricting production, either
directly or through incentives to producers
Price Supports: Under a Price Support Programme, the govt. sets a
support price, say Ps in Fig.8.10, and then buys up whatever output is
needed to keep the market price at this level. Impact of Price Support
on:
Consumers- consumers lose by an amount
CS = -A B

Producers- producers gain by an amount

PS = A + B + D
The Government: there is also a cost to the government which must be
paid for by taxes,and ultimately be borne by consumers. The cost is
equal to (Q2 Q1)Ps in Fig 9.10. The cost may be reduced if the
government can sell them abroad at a lower price.
The total welfare cost of the policy:
CS + PS Cost to Govt
=D (Q2 Q1) Ps
Production Quotas
The government can also cause the price of a good to rise by reducing
supply. It can do this by setting quotas on how much each firm can
produce (e.g. control of liquor licences by state governments. In this
case the deadweight loss is equal to triangles B and C (Fig. 8.11)
The

Impact

of

Tax

or

Subsidy

What would happen to the price of widgets if the government imposed

a $1 tax on every widget sold. The burden of a tax falls partly on a
consumer and partly on a producer
After the imposition of a tax, the price the buyer pays must exceed the
net price the seller receives by t cents (Fig. 8.17)
Before the imposition of the tax Po and Qo represent the market price
and quantity. After the imposition of a tax Pb is the price the buyer
pays and Ps is the net price the seller receives
Buyers lose A + D, sellers lose D + C, and the Govt. earns A + D in
revenue. The deadweight loss is B + C
If demand is relatively elastic and supply is relatively inelastic, the
burden of the tax will fall more on sellers, and vice versa
In general, a tax falls mostly on the buyer if Ed/Es is small, and mostly
on the seller if Ed/Es is large
When the pass-through fraction is 1(totally inelastic), all the tax is
borne by consumers. When the pass-through is zero(totally elastic), all
the tax is borne by producers
A subsidy can be taken as a negative tax. Like a tax a subsidy is split
between buyers and sellers, depending on the relative elasticities of
supply and demand
With a subsidy, the sellers price exceeds the buyers price, and the
difference between the two is the subsidy.

In general, the benefit of a subsidy accrues mostly to buyers if Ed/Es is

small and mostly to sellers if Ed/Es is large