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EC111LectNG4

# EC111LectNG4 - University of Essex Department of Economics...

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1 University of Essex Session 2011/12 Department of Economics Autumn Term EC111: INTRODUCTION TO ECONOMICS Consumer surplus Consider the consumer choosing an amount of good X to maximise his/her utility, and suppose that good Y is a composite of all other goods. Suppose we think of discrete units of good X. At P X1 the consumer will buy only one unit; his/her marginal utility from that good is high relative to all other goods. As the price falls the consumer becomes willing to buy more units and his marginal valuation of the good (relative to all others) falls. This underpins our interpretation of the demand curve as a marginal willingness to pay schedule. Note that when the price is P X6 , the total marginal valuation that the consumer places on good X is the sum of the area of the boxes representing each unit. The marginal valuation of the last unit is equal to the price but the consumer values the intra-marginal units more highly. P X P X1 P X2 P X6 1 2 3 4 5 6 q X

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2 Drawing the demand curve as continuous rather than discrete. At price P X1 the consumer’s total valuation is the area under the demand curve up to q X1 . The cost to the consumer of consuming this amount is q X1 ×P X1 (the area of the box) Consumer s urplus is the difference between the consumer’s total valuation and the total cost. It is the area under the demand curve down to the price. Note that in principle this is measurable as a monetary value. One interpretation of consumer surplus: The maximum lump sum payment consumer would be willing to make (in addition to the price for each unit) in order to be allowed to consume any of the good. In some settings firms can exploit this to extract more revenue from the consumer by charging an ‘entry’ fee and then a price per unit (a two-part tariff). Q: Think of an example. Consumer surplus P X P X1 q X1 q X Total expenditure
3 Market demand and supply There is an analogous concept for producers. The area above the supply curve up to the price represents the total surplus over the price at which producers would be willing to supply each unit. The sum of producer and consumer surplus is social surplus. It is a money-metric measure of the welfare generated in this market. At the equilibrium price P X1 consumers’ marginal wil lingness to pay is just equal to producers opportunity cost of supplying that unit. This is where social surplus is maximised. Suppose that for some reason producers were able to set price P X2 . Producer surplus would increase and consumer surplus would fall but the triangle below the demand curve and above the supply curve between Q X1 and Q X2 is lost. This loss of social surplus is the deadweight loss of the ‘distortion’ Q: Economists often use the term ‘distortion’. What does it mean?

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EC111LectNG4 - University of Essex Department of Economics...

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