Chapter 7 Notes: Economic Surplus and Exchange (Market Interventions)
7.1 – Pre-Conditions for Markets
Metaphor by Adam Smith that under carefully specified circumstances, the
actions of independent buyers and sellers will result in the largest possible
The benefit of any action minus its costs
An example of economic surplus:
Suppose you are willing to pay a maximum of $40 for a sweatshirt. You go
shopping and discover another sweatshirt priced at $30 that meets your specifications. If I
pay $30 for the sweatshirt, I realize an economic surplus of $10.
Buyer aspect: my willingness to pay $40 reveals that the value of the sweatshirt to
me is $40
Seller aspect: Suppose that the seller is willing to sell the sweatshirt at $25. If the
seller receives $30 for the sweatshirt, the seller will realize an economic surplus
This transaction is mutually beneficial because both the buyer and seller realize an
The “right” competition circumstances include competition among a large number of
small participants in markets (therefore market price is unaffected).
Therefore, societies need laws and courts to enforce “right” competition to ensure
competition takes legitimate forms
1 Perfectly competitive markets
A market in which no individual supplier has significant influence on the market
price of the product
A firm cannot charge more than a rival firm nor does the incentive to charge less
Perfectly competitive firms are price takers because of their inability to influence market
A firm that has no influence over the price at which it sells its product.
Four conditions are needed to satisfy the assumption of a perfectly competitive market:
1. All firms sell the same standardized product. This condition implies that
buyers are willing to switch sellers if it allows them to buy at a lower price.
2. The market has many buyers and sellers, and each buys or sells only a small
fraction of the total quantity exchanged. This implies that individual buyers and
sellers are price takers, regarding the market price of the product as fixed and
beyond their control.
3. Productive resources are mobile; that is, both buyers and sellers are able to
move their resources freely between markets in pursuit of business
4. Buyers and sellers know the market price and quality of the standardized
2 Three good reasons to study perfect competition:
1. Some markets (e.g., foreign exchange, many agricultural products) are closer to
perfect competition than to other market types.
2. It is easier to first analyze perfect competition and then proceed to other market
types than it is to do the reverse.
3. When individuals make mutually beneficial transactions in a perfectly
competitive market, their self-interested behaviour is harmonized with the
common good. Therefore, perfect competition provides a benchmark against
which the outcomes of other market types can be compared.
For an example that approximates perfect competition, consider how well the market
faced by a wheat farmer in Manitoba meets the criteria:
1. The different grades of wheat are highly standardized with very specific criteria
2. Each farmer's crop is only a fraction of Canadian and world wheat production.
Even when the Canadian Wheat Board acted for many years as sole sales agent
for Canadian wheat exports, it had no control of world wheat market prices.
3. Some farmers can choose to produce other crops even if they are unwilling to
leave farming, which provides a degree of mobility of resources.
All buyers and sellers can be well informed because the Internet provides access to
information about prices and grades of wheat as published by the Canadian Wheat
Board and others.
3 A) Shows the market demand and supply curves intersecting to determine a market
price of P 0
B) Shows the product demand curve as faced by any individual firm in this market
that is a horizontal line at P0.
Since the market is perfectly competitive, firms must accept the price at which they sell
their goods and services. The firm has only one decision to make: the output level is
chosen that enables the largest possible profit.
7.2 – Market Equilibrium and Mutually Beneficial Exchange
Suppose the supply and demand curves for milk are as shown in Figure 7.2, and the
current price of milk is $1/litre. Describe an unrealized transaction that would benefit
both buyer and seller.
At a price of $1, sellers offer 2000 litres of milk per day. At this quantity, buyers
value an extra litre of milk at $2 (the buyers’ willingness to pay for an additional litre).
The cost of producing an extra litre of milk is only $1 (the price that corresponds to 2000
litres/day on the supply curve, which is equal to the marginal cost). Therefore, a price of
$1/litre leads to excess demand of 2000 litres/day.
Suppose a supplier sells an extra litre of milk to the most eager of these potential
buyers at $1.25…
How Excess Demand Creates an Opportunity for a
At a market price of $1/litre, the most intense potential
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 potential buyer
gains an economic surplus of $0.75 and the seller gains an
economic surplus of $0.25.
4 If compensating payments can be made to those who lose when the price of milk
rises, it is possible for additional buyers and sellers to be better off while no one is worse
Therefore, selling milk at $1 does not provide the largest possible economic
surplus. It prevents mutually beneficial exchange. If milk sells at a price below its
equilibrium price, we can design a transaction in which each participant’s benefit exceeds
QUESTION: Suppose that milk initially sells for 50 cents per litre. Describe a transaction
that will create additional economic surplus for both buyer and seller without causing
harm to anyone else.
A Market in Which Price is Below the
In this market, milk is currently selling for
$1/litre, $0.50 below the equilibrium price of
ANSWER: At a price of 50 cents per litre, there is excess demand of 4000 litres/day.
Suppose a seller produces an extra litre of milk (MC = $0.50) and sells it to the buyer
who would value it most (reservation price = $2.50) for $1.50. Both buyer and seller will
gain an additional economic surplus of $1, and no other buyers or sellers will be hurt by
5 FIGURE 7.4
How Excess Supply Creates an Opportunity for a
At a market price of $2/litre, buyers are only willing to
purchase 2,000 litres. At that quantity of total
production, sellers can produce an additional litre of
milk at a cost of only $1, which is $1 less than the
marginal buyer would be willing to pay for it. If the
buyer pays the seller $1.75 for that extra litre, the buyer
gains an economic surplus of $0.25 and the seller gains
an economic surplus of $0.75.
If exchange is voluntary, neither the buyer nor the seller can be compelled to purchase or
sell more than is optimal for them given the going price.
Prices read from the supply and demand curves thus make it clear why
opportunities for additional mutually beneficial exchanges cease only if the
equilibrium price pertains in a market.
When the price is either higher or lower than the equilibrium price, the
quantity exchanged in the market will always be lower than the equilibrium
quantity. If the price is below equilibrium, the quantity sold will be the
amount that sellers offer.
The price on the demand curve at the quantity exchanged (the value of an extra unit to
buyers) must be larger than the seller's reservation price on the supply curve (the
marginal cost of producing that unit).
7.3 – Economic Surplus
Total economic surplus is the sum of all economic surpluses attributable to participation
in that market by buyers and sellers. It is a measure of the total amount by which
buyers and sellers benefit from their participation in the market.
A perfectly competitive market maximizes its economic surplus when it reaches
equilibrium price and quantity
6 Supplier’s reservation price is the lowest price a supplier will accept in return for
providing a service.
Demander’s reservation price is the highest price a demander will offer in order to obtain
a good or service.
Consumer and Producer Surplus
Consumer surplus (blue area) is the
cumulative difference between the
most that buyers are willing to pay for
each unit and the price they actually
pay. Producer surplus (green area) is
the cumulative difference between the
price at which producers sell each unit
and the smallest amounts they would
be willing to accept.
When the potential purchasers are arranged from highest to lowest reservation price,
demand forms the staircase-shaped demand curve.
The supply and demand curves of this figure can be thought of as discrete counterparts of
the traditional continuous supply and demand curves.
the total economic gain of the buyers of a product as measured by the cumulative
difference between their respective reservation prices and the price they actually
the cumulative difference between what buyers would have been willing to pay
for the product and the price they actually do pay. Graphically, it is the area
between the demand curve and the market price.
7 Producer surplus:
the total economic gain of the sellers of a product as measured by the cumulative
difference between the price received and their respective reservation prices
the cumulative difference between the market price and the reservation prices at
which producers would have been willing to make their sales. Graphically, it is
the area between market price and the supply curve.
The surplus received by buyers and sellers will generally not be the same dollar value.
The total economic surplus for a market is the sum of consumer surplus and producer
surplus. Total economic surplus in a perfectly competitive market is maximized when
exchange occurs at the equilibrium price.
How much do buyers and sellers
benefit from their participation in
the market for milk?
How much total economic surplus
do the participants in this market
Total economic surplus = Producer Surplus + Consumer Surplus
= Area of Green Triangle + Area of Blue Triangle
The last unit exchanged generates no surplus at all for both buyers and sellers.
For sellers, the surplus is the cumulative difference between market price and
For buyers, the surplus is the cumulative difference between the most they would
be willing to pay for milk and the price they actually pay.
8 Another way to think about surplus is to ask, what is the highest amount
consumers and producers would pay, for the right to continue participating in the
For buyers, it is $2000/day. This is the amount by which their combined benefits
exceed their combined costs.
For sellers, it is $4000/day, since that is the amount by which their combined benefits
exceed their combined reservation prices.
The equilibrium price and quantity serve to maximize the total economic surplus created
by a market.
The prices and quantities that we observe as equilibrium outcomes in markets are
conditional on tastes and the distribution of wealth.
Whenever a perfectly competitive market is out of equilibrium, it is always possible to
generate additional economic surplus. A larger economic surplus means that, at least
potentially, it is possible to make at least some people better off without making anyone
7.4 – The Cost of Preventing Price Adjustments:
Price ceiling: a maximum allowable price, specified by law or regulation (e.g. rent
How much is an economic surplus reduced by price control?
9 And suppose that legislators pass a law
setting the maximum price at $10/bbl. How
much lost economic surplus does this policy
For the supply and demand curves shown, the equilibrium price of oil is $14/bbl, and the
equilibrium quantity is 3000 bbl/day. Consumer surplus is the area of the blue triangle
($9000/day). Producer surplus is the area of the green triangle (also $9000/day).
Total economic surplus in this market will be $18 000/day.
If the price of oil is kept at $10/bbl, only
1000 bbl/day will be sold, and the total
economic surplus will be reduced by the
area of the lined triangle.
Since the height of this triangle (lost economic surplus) is $8/bbl and its base is 2000
bbl/day, its area is (½)(2000 bbl/day)($8/bbl) = $8000/day.
Producer surplus falls from $9000/day in the unregulated market to the area of the green
triangle, or (½)(1000 bbl/day)(2/bbl) = $1000/day, which is a loss of $8000/day.
Note that consumer surplus under controls is the area of the blue figure, which is again
(Hint: To compute this area, first split