Some More Micro-Foundations for CBA

• Consumer Surplus– The difference between what consumers would

have been willing to pay and what they actually did pay.

– Economic surplus gained by the buyers of a product.

– Measured by the cumulative difference (adding up over all consumers) between their reservation price for each unit of the good, and the price they pay .

Consumer Surplus

© 2012 McGraw-Hill Ryerson Limited Ch7-2

LO3: Graphical representation of consumer surplus, producer surplus, and total economic

surplus

• Producer Surplus– The difference between what producers do get for

output and the minimum price they would have been willing to accept.

– Economic surplus gained by the sellers of a product.– Measured by the cumulative difference (adding up

over all producers) between the price they receive and their reservation price for each unit of the good.

Producer Surplus

© 2012 McGraw-Hill Ryerson Limited Ch7-3

LO3: Graphical representation of consumer surplus, producer surplus, and total economic

surplus

Consumer and Producer Surplus

S

D

Consumer surplus

Producer surplus

© 2012 McGraw-Hill Ryerson Limited Ch7-4

LO3: Graphical representation of consumer surplus, producer surplus, and total economic

surplus

: How Excess Demand Creates an Opportunity for a Surplus-Enhancing Transaction

S

D

1.25

© 2012 McGraw-Hill Ryerson Limited Ch7-5

$0.75

$0.25

At a market price of $1/litre, the most intensely dissatisfied buyer is willing to pay $2 for an additional litre, which a seller can produce at a cost of only $1. If this buyer pays the seller $1.25 for the extra litre, the buyer gains an economic surplus of $0.75 and the seller gains an economic surplus of $0.25.

How Excess Supply Creates an Opportunity for a Surplus-Enhancing Transaction

S

D

1.75

At a market price of$2/litre, dissatisfied sellerscan produce an additionallitre of milk at a cost of only$1, which is $1 less thana buyer would be willingto pay for it. If the buyerpays the seller $1.75 for anextra litre, the buyer gainsan economic surplus of$0.25 and the seller gains aneconomic surplus of $0.75.

© 2012 McGraw-Hill Ryerson Limited Ch7-6Market Equilibrium and Mutually

Beneficial Exchange

$0.25

$0.75

Public vs. private goods

Private goods – demand sums horizontally

Public goods – demand sums vertically

Consumer A demand falls to 0

MB is the marginal social benefit

Valuation in efficient markets – no effect on price.

• Increase in supply has no effect on price.• Gross social benefits = net government

revenue generated by the program + change in social surplus.

• Supply shift to the right (publicly provided good) increases benefits to consumers (S → S+q’).

− The cost to the consumer of the new amount (q’) is offset by the benefits of consuming more

− Only benefit is the increased revenue to supplier – government or (abq1q0)

• Supply shifts due to cost reduction which increases benefits to producers.

− Benefit is the increase in producer surplus (abde)

Valuation in efficient markets – supply reduces price

• Downward sloping demand• Increase in supply cases price to fall and

change in social surplus is abc. Three scenariosa. If goods are distributed free the

increase in consumer surplus is cbq1q0 and the total is area abc + cbq1q0

b. If good goes to consumers without charge, some receive the product who would not have purchased at P1.

c. Assume q due to increase in supply arises from cost reduction

− increase in consumer surplus is P0P1ab

−change in producer surplus is P0ae-P1bd or ecbd-P0abP1

• Note that that the last scenario is the most realistic.

Valuation in inefficient markets – monopoly power reduces price

• Monopoly – market demand is the revenue schedule

• Marginal revenue is lower than the average revenue (MA<AR).

• Profit maximization at MC=MR• Consumer surplus – P0Pma• Producer surplus – Pmabx• The social surplus under monopoly is P0abx• The social surplus under competition is P0cX.• The deadweight loss is the reduction in social

surplus due to monopoly.

P0

X

Natural Monopoly

• Always defined by falling average cost over the region where demand exists for any price >0

• Typical in capital intensive industries, or industries with high entry/exit barriers, and knowledge barriers

• Policies to deal with natural monopoly− Ignore and accept deadweight loss − Regulate (price so that price set at AC =

AR)− Regulate (price so that MC=AR) − Allow free access (accept social cost that

demand exceeds marginal cost)• Natural monopolies usually erode due to

technical change – high profits create incentives to innovate.

• Policy may create temporary monopolies to induce innovation (e.g., pharmaceuticals).

Demand > 0, AC falling

Information asymmetry

• Present in every market• Imbalance between information held by

sellers and buyers− Buyers can have the edge in labour

markets (they know what the job truly entails)

− Sellers (job applicants) can have the edge if they fabricate experience.

• Where sellers have information, the presumption is that the demand would fall as addition product/service attributes become known to the buyer (Du → Di).

• The information asymmetry transfers PuPica to the seller from the buyer, and the deadweight loss is acd.

• Policies− Caveat venditor and caveat emptor− Private market (Consumer Reports)− Public provision of information)

Negative Externality Externalities create a divergence of marginal private and marginal social costs. • Negative externality MSC > MPC• Positive externality MSC < MPC• Negative externality reduces consumer and

producer surplus• S# - S* = social costs = WTP to avoid the costs.• Market will under price good/service and too

much is produced.• Taxation is the standard policy with the level set

“t”, price shifts to P# and quantity drops to Q#.Positive externalities work in reverse, subsidies to increase consumption.

Benefits CostsConsumer A + B

Producer E + F

Third Parties B + C + F

Gov. Rev. A + E

Social Benefit C