lnc5doubleprime - Notes 5 Consumer and Producer Surplus...

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Notes 5 ’. Consumer and Producer Surplus; Price Controls A. Consumer and Producer Surplus (IMPORTANT NOTE: Some students find the terms consumer and producer ―surplus‖ confusing. These terms have nothing at all to do with surplus (and shortage) as discussed in chapter 4. It would probably be clearer to call them consumer and producer ―bonus‖ or something, since that’s what they really are— bonuses from making trades but if you did, no one else would know what you’re talking about.) Back in Chapter 2, we learned about the Principle of Voluntary Exchange: A voluntary exchange between two people makes both people better off. If this is so, then we should be able to show it on a graph. (Remember, this is economics.) Let’s start with the market for dog food shown in equilibrium in Figure 1. In initial equilibrium, price (Pe) is $10 and quantity (Qe) is 500 bags per week. Recall what each of these curves represents. If we think of a city the size of Decatur, and imagine a big open-air auction market for dog food, there would be lots of potential buyers, some willing to pay higher prices than others. Say that Joe is willing to pay more for a bag of dog food than any other buyer in the market, and so if a single bag is auctioned off, Joe will get it although, in auction, he would have to pay a price approximately equal to his reservation price (the highest price he is willing to pay to avoid going without dog food for this dog, that is). Say this is $20. Joe would be sitting at the very top end of the market demand curve. (If you look closely you’ll see him.) The next highest willing bidder would be just below him, and so on. Likewise, sellers would differ in their production costs, with some being lower, some higher. If Carrie is the lowest cost producer, she would be located on the lower left end of the market supply curve, with higher cost producers ranging on up to the right. (Carrie said her hair wasn’t done and would never speak to us again if we showed her in the figure.) consumer producer { } utility revenue { } A surplus is the extra , i.e., the net benefit, the receives from a trade. consumer producer { } consumer’s producer’s { } Thus, it is the gain from trade. below the demand above the supply { } paid received { } above below { } Graphically, it is the area the price and curve. P Q D S ($10) P e Figure 1. Mkt. Equilibrium Q e (500)
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Now, dog food isn’t usually sold at auction in this way, as the transactions costs are too high. In a grocery or pet store, it’s sold at a fixed price approximating the equilibrium level for all trades made. 1 Let’s look at the 150 th bag sold in Figure 2, i.e., the bag sold to the buyer with the 150 th highest reservation price , whom I’ll call Roger. Say the equilibrium price is $10. If Roger would be willing to pay a price as high as $15, it must be because he expects to benefit by an amount equal to $15. Likewise, if the
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lnc5doubleprime - Notes 5 Consumer and Producer Surplus...

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