ECO 100: TEST 1 REVIEW
CONSUMER SURPLUS: NUMERICAL EXAMPLE
Suppose that the market DD and SS determine an equilibrium price of $5. Your demand curve is as follows:
Price Quantity Consumer Surplus
$20 1 $15 = (20 – 5)
$15 2nd $10 = (15 – 5)
$10 3rd $5 = (10 – 5)
$5 4th None
You will purchase 4 units and enjoy consumer surplus of $30 = ($15 + $10 + $5 + 0)
The graph is a non-linear step function.
Note: On test 1, students are not required to graph the step-like demand curve that arises in this case!
ALLOCATIVE EFFICIENCY OF COMPETITIVE MARKETS
P Area = Gains from Trade (Total Surplus)
All possible prices
resulting in gains
When total surplus is maximized, we have allocative efficiency. Definition: we have AE when the value to the buyer = cost to sellers of the last good sold (intersection of the demand & supply
Q1: To the left oE Q ;
VALUE TO BUYER > COST TO SELLERS
efficient to increase output
Q2: To the right oE Q ;
VALUE TO BUYER < COST TO SELLERS
efficient to reduce output
Q1 QE Q2 Q
Question: How much, in total, would consumers and producers pay to prevent this market from shutting down?
Answer: CONSUMER SURPLUS + PRODUCER SURPLUS = TOTAL SURPLUS
If output of a good is less than output in a competitive market (ie equilibrium), output is too low and is “allocatively inefficient”
1) the value of the good to the buyers exceeds the cost to sellers of producing the good
2) the “gains from trade” – the benefits of participating in the market – are not fully realized
CS = DD – PE
PS = PE – SS
AE focuses on maximizing total surplus.
Distribution of total surplus is irrelevant.
Q E Implication:
Government policies that prevent output from reaching the competitive level result in allocative inefficiency
Price Ceiling: if beneath market price, produces shortage (as previously discussed)
In more sophisticated framework (welfare analysis), also results in loss of total surplus
Dead Weight Loss:
Consumer loss in total surplus
QC Q E
1) Price ceiling (P ) is beneath equilibrium market price
2) Consumer surplus increases, a