APPLIED ECONOMICS

UNIT ECONOMIC
4 SURPLUS

LET’S GET
STARTED
After studying this Unit, you will be able to:
1. Explain the relationship between price and quantity demanded
2. Illustrate consumer surplus with the demand schedule and demand curve
3. Explain how shifting a price away from pareto optimal will impact consumer surplus
4. Summarize the relationship between market power and a firm’s supply decision
5. Define producer surplus
6. Examine producer surplus in terms of changes in demand, supply, price, and price
elasticity

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CONSUMER SURPLUS
Willingness to Pay and the Demand Curve
In general, as the price of a good increases, the quantity demanded of that good
decreases.
A demand curve is the graphical depiction of the relationship between the price of a
certain commodity and the amount of it that consumers are willing and able to purchase at that
price. Demand curves are used to estimate behaviors in competitive markets and are often used
with supply curves to estimate the market equilibrium price, or the price at which sellers are
willing to sell the same amount of a product as the market’s buyers are willing purchase. A
demand graph can reflect the preferences of a single consumer, a group of consumers or an
entire market. For demand graphs that reflect a group, the individual demands at each price are
added together.
Demand is the willingness and ability of a consumer to purchase a good under the
prevailing circumstances. It is defined by three elements:
• Individual Utility: An item’s utility is based on its ability to satisfy an individual’s needs
or wants. Some utility is universal; every human needs water to survive so it has high
utility for everyone. Some utility is based on personal preference; some people prefer
Coke over Pepsi so for them Coke has the higher utility. The more people that find
utility in the good the greater the market demand; the greater the individual utility in
the product the greater the individual demand.
• Purchasing Power: Demand is measured based on a person’s willingness to buy under
the prevailing circumstances. If an individual lacks the money to purchase the product,
she can’t demand it because she cannot afford it.
• Ability to Decide: The individual must be able to choose to make a purchase.
Sometimes circumstances may prevent a person from purchasing something they
might desire, even if they have the necessary money. For example, an underaged
person may not be permitted by law to purchase cigarettes. That person might want
the cigarettes and can afford to purchase them, but since it is against the law for him
to purchase it, there is no demand.
For the vast majority of goods and services, an increase in price will lead to a decrease in
the quantity demanded. There are two exceptions to this general rule.

Figure 40. Supply and demand graph: The

downward sloping demand curve reflects the fact
that as price increases, consumers willing to
purchase less of the good or service.

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Veblen Goods
Veblen goods are expensive luxury products, such as designer handbags and high-end
cars. In these rare circumstances, decreasing the price actually decreases the demand for the
good. The reason for this is because part of the value of the good is exclusivity. These items are
status symbols and lowering the price diminishes the status.

Giffen Goods
Giffen goods are another example where rising prices can lead to increased demand for
a product. Giffen goods are very rare and are defined by three characteristics:
• It is an inferior good, or a good for which demand decreases as consumer income
rises,
• There must be a lack of substitute product,
• The good must constitute a substantial percentage of the buyer’s income, but not
such a substantial percentage of the buyer’s income that none of the associated
normal goods are consumed.
For example, imagine a significant portion of a family’s grocery bill is bread. Bread is a
staple and it is the cheapest option out of the food available. If bread prices rise, the family will
need to cut back on other groceries to make up the difference. However, since the family still
need to eat a certain amount of calories each day and bread is still the cheapest option, they will
purchase more bread to make up for the food they aren’t purchasing and consuming. In this
instance, bread is a giffen good.

The Demand Curve and Consumer Surplus

Consumer surplus is the difference between the maximum price a consumer is willing to
pay and the actual price they do pay.
Consumer surplus is the difference between the maximum price a consumer is willing to
pay and the actual price they do pay. If a consumer would be willing to pay more than the current
asking price, then they are getting more benefit from the purchased product than they spent to
buy it. Consumer surplus plus producer surplus equals the total economic surplus in the market.

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This chart graphically illustrates consumer surplus in a market without any monopolies,
binding price controls, or any other inefficiencies. The price in this chart is set at the pareto
optimal. This means that the price could not be increased or decreased without one of the parties
being made worse off. The consumer surplus, as marked in red, is bound by the y-axis on the left,
the demand curve on the right, and a horizontal line where y equals the equilibrium price. This
area represent the amount of goods consumers would have been willing to purchase at a price
higher than the pareto optimal price. Generally, the lower the price, the greater the consumer
surplus.

Figure 41. Consumer Surplus:

Consumer surplus, as shown
highlighted in red, represents the
benefit consumers get for
purchasing goods at a price lower
than the maximum they are
willing to pay.

Another way to define

consumer surplus in less
quantitative terms is as a
measure of a consumer’s well-
being. Some goods, like water,
are valuable to everyone because
it is a necessity for survival. But
the utility, or “usefulness,” of
most goods vary depending on a
person’s individual preferences.
Since the utility a person gets
from a good defines her demand
for it, utility also defines the consumer surplus an individual might get from purchasing that item.
If a person has no use for a good, there is no consumer’s surplus for that person in purchasing
the good no matter the price. However, if a person finds a good incredibly useful, consumer
surplus will be significant even if the price is high. An individual’s customer surplus for a product
is based on the individual’s utility of that product.

Impacts of Price Changes on Consumer Surplus

Consumer surplus decreases when price is set above the equilibrium price, but increases
to a certain point when price is below the equilibrium price.
Consumer surplus is defined, in part, by the price of the product. Recall that the consumer
surplus is calculating the area between the demand curve and the price line for the quantity of
goods sold. Assuming that there is no shift in demand, an increase in price will therefore lead to
a reduction in consumer surplus, while a decrease in price will lead to an increase in consumer
surplus.

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Below are two scenarios that illustrate how changes in price can affect consumers’ surplus. It is
important to note that any shift from the good’s pareto optimal price will result in a decrease in
the total economic surplus. The total economic surplus equals the sum of the consumer and
producer surpluses.

Figure 42. Consumer Surplus: An increase in the price will reduce consumer surplus, while a
decrease in the price will increase consumer surplus.

Price Ceiling
A binding price ceiling is one that is lower than the pareto efficient market price. This
means that consumers will be able to purchase the product at a lower price than what would
normally be available to them. It might appear that this would increase consumer surplus, but
that is not necessarily the case.
For consumers to achieve a surplus they have to be able to purchase the product, which
means that producers have to make enough to be purchased at a price. If a good’s price drops
below the market equilibrium for whatever reason, manufacturing the product will be less
profitable for the producers. So while more consumers will want to purchase the product

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because of its low price, they will not be able to. This means the market will have a shortage for
that good. This shortage will create a deadweight loss, or a market wide loss of efficiency and
value that neither producer nor consumers obtain.
So any increase in consumer surplus due to the decrease in price may be offset by the fact
that consumers that want the good cannot purchase it. At some point the benefit from the drop
in price will be outweighed by the decrease in the good’s availability.

Price Floor
When a price floor is set above the equilibrium price, consumers will have to purchase
the product at a higher price. Therefore, fewer consumers will purchase the product because
some will decide that the utility they get from the good is not worth the price. Necessarily, this
reflects a drop in consumer surplus.

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PRODUCER SURPLUS
Market Power
Market power is a measure of a firm’s economic strength that affects its pricing and
supply decisions.
Market power is a measure of the economic strength of a firm. It is the ability of a firm to
influence the quantity or price of goods and services in a market. A firm is said to have significant
market power when price exceeds marginal cost and long run average cost, so the firm makes
economic profits. Such firms are often referred to as “price makers.” In contrast, firms with
limited to no market power are referred to as “price takers.”

Determinants of Market Power

A firm usually has market power by virtue of controlling a large portion of the market.
However, market size alone is not the only indicator of market power. Other factors that affect a
firm’s market power include:
• Number of producers
• Size of firms in the market
The numbers and size of firms determine the extent that firms can withstand pressures
and threats to change prices or product flows. However, being a large firm does not necessarily
equal market power. For example, while conglomerates may be very large, they may play only
small roles in many different markets and have no ability to influence prices in any of them.
• Barriers to entry
Barriers to entry determine how contestable the market is. Even highly concentrated
markets may be contestable markets if there are no barriers to entry or exit, which limits a firm’s
ability to raise its price above competitive levels.
Common barriers to entry include control of a scarce resource, increasing returns to scale,
technological superiority, and government-imposed barriers.
• Availability of substitute goods
Greater availability of substitute goods will weaken a firm’s market power.

Relationship between Market Power and Firm Behavior

A firm’s market power influences its behavior. For example, market power gives firms the
ability to engage in unilateral anti-competitive behavior. Some of the behaviors that firms with
market power are accused of engaging in include predatory pricing, product tying, and creation
of overcapacity or other barriers to entry. If no individual participant in the market has significant
market power, then anti-competitive behavior can take place only through collusion, or the
exercise of a group of participants’ collective market power.
A monopoly, a price maker with market power, can raise prices and retain customers
because the monopoly has no competitors. If a customer has no other place to go to obtain the
goods or services, they either pay the increased price or do without.
An oligopoly may also be a price maker with market power, as firms may be able to collude
and control the market price or quantity demanded.
A perfectly competitive firm, a price taker with no market power, cannot raise its price
without losing its customers.
Measurement of Market Power

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Measurement of market power is often accomplished with concentration ratios or the

Herfindahl-Hirschman Index (HHI).

Concentration Ratios
The concentration ratio is the proportion of total industry output produced by the largest
firms (usually the four largest). This measure of market power relates the size of firms to the size
of the market. For monopolies, the four firm concentration ratio is 100 percent, while the ratio
is zero for perfect competition.

Herfindahl-Hirschman Index (HHI)

The Herfindahl-Hirschman Index (HHI) is a measure of the size of firms in relation to the
industry, and an indicator of the amount of competition among them. The HHI is calculated by
summing the squares of the percentage market shares of all participants in the market. The HHI
for perfect competition is zero; for a monopoly, it is 10,000.
For example, if a market consists of five firms with market shares of 40, 20, 20, 15,
and 5 percent each, the HHI is 2650 (402+202+202+152+52=2650).

Measurement Problems
The use of the concentration ratio or the HHI to measure market power is not perfect. A
high concentration ratio or large firm size is not the only way to achieve market power. Many
smaller firms acting in unison can achieve the same result. Additionally, the measurements do
not convey the extent to which market power may be concentrated in a local market.

Defining Producer Surplus

Producer surplus is the difference between the amount producers get for selling a good
and the amount they want to accept for that good.
Producer surplus is the difference between what price producers are willing and able to
supply a good for and what price they actually receive from consumers. It is the extra money,
benefit, and/or utility producers
get from selling a product at a price
that is higher than their minimum
accepted price, as shown by the
supply curve.

Figure 43. Economic Surplus:

Producer surplus is the shaded area
directly above the supply curve, up
to the equilibrium point. Consumer
surplus is the shaded area directly
under the demand curve, up to the
equilibrium point.
For example, above, the
equilibrium price is P′. However,
at P1, the producers are willing to

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sell one unit of a commodity for a price that is lower than P′. The resulting rectangle from P1 on
the y-axis, to its intersection with the supply curve, up to the level of P′ is the producer surplus
at price level P1.
Similarly, at P2, the producers are willing to sell two units of a commodity at a price that
is still lower than P′. The rectangle from P2 on the y-axis, to its intersection with the supply curve,
up to the level of P′ is the new producer surplus at price P2. The total producer surplus at P2 is the
first rectangle at the P1 price, plus the new rectangle from the P2 price.
This process is repeated for every price level up to the equilibrium price. To find the
resulting total producer surplus, all of the rectangles for the individual price levels are added
together, and the total area is the total producer surplus. Below, the total producer surplus is
made of all three pink rectangles – the surpluses at price levels of P1, P2, and P3 – added together.

Figure 44. Producer surplus: In the figure, producer surplus at different prices is represented by
the pink rectangles.

Impact of Changing Price on Producer Surplus

Producer surplus is affected by changes in price, the demand and supply curve, and the
price elasticity of supply.
Producer surplus is affected by many different factors. Changes in the price level, the
demand and supply curves, and price elasticity all influence the total amount of producer surplus,
other things held constant.

Changes in Price
Changes in price are directly associated with the amount of surplus a producer will
receive. Graphically, the producer surplus is directly above the supply curve, but below the price.
Other things equal, as equilibrium price increases, the amount of potential producer surplus and
the number of goods supplied increases. Lower prices result in lower potential producer surplus
and goods supplied: with a lower equilibrium price, the producer surplus triangle will be smaller.

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Figure 45. Economic Surplus: The

producer surplus is directly above
the supply curve and is shaded in
blue.

Demand Curve
Shifts in the demand curve are directly related to the amount of producer surplus. If
demand decreases, and the demand curve shifts to the left, producer surplus decreases.
Conversely, if demand increases, and the demand curve shifts to the right, producer surplus
increases.
At an initial demand represented by the “Demand (1)” curve, producer surplus is the blue
triangle made of P1, A, and B. When demand increases, represented by the “Demand (2)” curve,
producer surplus is the larger gray triangle made of P2, A, and C.

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Figure 46. Producer Surplus and the Demand Curve: If the demand curve shifts out, producer
surplus increases, as seen by size of the gray triangle.

Supply Curve
Similarly, shifts in the supply curve are also directly related to the amount of potential
surplus. Decreases in the supply curve will cause decreases in producer surplus. Increases in the
supply curve will cause increases in producer surplus.
At an initial supply represented by the “Supply (1)” curve, producer surplus is the blue
triangle made of P1, A, and C. If supply increases, represented by the “Supply (2)” curve, producer
surplus is the larger gray triangle made of P2, BB, and DD.

Price Elasticity of Supply

Price elasticity of supply is the relationship between price and quantity changes. It
measures how quantity supplied is affected by changes in price. When supply is elastic, producers
can increase production without much price or cost change. When supply is inelastic, producers
cannot change production easily.
When supply is perfectly elastic, it is depicted as a horizontal line. Producer surplus is zero
because the price is not flexible. Producers cannot provide a higher price than market price.
When supply is perfectly inelastic, it is depicted as a vertical line. Producer surplus is
infinite because the price is completely flexible.

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LET’S SUM UP!

UNIT 1
Economics also allows individual agents to balance expectations.
Economics provides distilled frameworks to analyze complex societal interactions, as in the
case of consumer and firm behavior.
Being knowledgeable about economics foundations allows an individual to be an active and
aware participant rather than a passive economic agent.
Economics incorporates both qualitative and quantitative assessment.
Economics is divided into two broad areas: microeconomics and macroeconomics.
Economics can be applied throughout society from business to individual behavior with
further application in the study of crime, family and other social institutions and interactions.
Scarce resources diminish as they are used and almost all resources are scarce.
In order to use a scarce resource, you are inherently using the resource for one purpose and
not an alternative.
The cost of using a resource is called the opportunity cost: the value of the next best
alternative that you could be using the resource for instead.
The opportunity cost is the value of the next best alternative foregone.
Individuals, firms, and governments all change incentives in hopes of encouraging desired
outcomes.
Firms generally appear and become prevalent as an alternative to individual trade when it is
more efficient to produce in a non-market environment.
Limited liability separates the management of a firm from its ownership, allowing companies
to raise money easily because owners do not need to risk everything in the case of
bankruptcy.
Most industries experience increasing returns to scale up to a point, which means that more
goods can be produced using fewer resources.
The benefit of exchange to producers is measured by the profit the producer makes. The
benefit of exchange to a consumer is measured by net utility gained.
Consumer surplus is the monetary gain obtained by consumers because they are able to
purchase a product for a price that is less than the highest price that they would be willing to
pay.
Producer surplus is the amount that producers benefit by selling at a market price that is
higher than the least that they would be willing to sell for.
An allocation of resources is Pareto efficient when it is impossible to make any one individual
better off without making at least one individual worse off.
Economists assume that firms seek to maximize their profits – defined as the difference
between total revenue and total cost – while consumers seek to maximize their utility – which
is roughly defined as the total satisfaction gained from goods, services, or actions.
An efficient allocation of resources maximizes total consumer and producer surplus.

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Because they produce efficient outcomes, the seemingly haphazard workings of the
marketplace can promote the common good.
Efficiency is but one of many vying goals in an economic system, and different notions of
efficiency may be complementary or may be at odds.
A market is defined as a system or institution whereby parties engage in exchange. A market
economy is an economy in which decisions regarding investment, production, and
distribution are based on supply and demand, and prices of goods and services are
determined in a free price system.
In a perfectly competitive market there are many buyers and sellers so no individual actor
may affect a good’s price; there are no barriers to exit or entry; products are homogeneous;
and all actors in the economy have perfect information.
if the price of a product that the market is supplying is equal to the value consumers place on
it.
It is important to note that achieving economic efficiency is not always the most important
goal for a society. A market can be perfectly efficient but highly unequal.
A smoothly functioning market requires that producers possess property rights to the goods
and services they produce and that consumers possess property rights to the goods and
services they buy.
Economic efficiency occurs under the following conditions: competitive markets with
accurate exchange of information and mobile resources, in which individuals bear the full
costs and benefits of their transactions.
The criteria for economic efficiency are rarely fully met.
If a transaction affect individual not involved in the transaction (either positively or
negatively), that transaction is said to have an externality.
Governments can intervene by taxing negative externalities or subsidizing positive
externalities.
Free markets will generally produce less than the optimal amount when a good is
nonexcludable and non-rivalrous, which means that a government can make the market
more efficient by producing the public good itself.
Macroeconomists combine the demand of all consumers in a market (aggregate demand) and
the supply from all producers in a market (aggregate supply) to look at the way these groups
interact on a large scale.
There are four types of market scenario that a firm may encounter when making a production
decision: economic profit, normal profit, loss-minimizing condition, and shutdown. The firm
should always produce unless it encounters a shutdown scenario.
Capital, otherwise known as capital assets, are manufactured goods that are used in
production of goods or services.
Cash is not included in capital in terms of a production input. Homes and personal
automobiles are also not included in capital because these items are not directly tied to the
production of
Unit 3
The demand curve is downward sloping, indicating the negative relationship between the
price of a product and the quantity demanded.

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For normal goods, a change in price will be reflected as a move along the demand curve while
a non-price change will result in a shift of the demand curve.
Two exceptions to the law of demand are Giffen goods and Veblen goods.
Demand curves are a graphical representation of a demand schedule, which is the table view
of an economic agents’ price to quantity relationship.
The graphical representation of a market demand schedule is called the market demand
curve.
Following the law of demand, the demand curve is almost always represented as downward-
sloping. This means that as price decreases, consumers will buy more of the good.
Two different hypothetical types of goods with upward-sloping demand curves are Giffen
goods and Veblen goods.
When ceteris paribus is employed in economics, all other variables with the exception of the
variables under evaluation are held constant.
An example of the use of ceteris paribus in macroeconomics is: what would happen to the
demand for labor by firms if a minimum wage was imposed at a level above the prevailing
wage rate, ceteris paribus.
An example of the use of ceteris paribus in microeconomics is: what would happen for the
demand for a normal good when income increases, ceteris paribus.
A change in price will result in a movement along a demand curve.
A change in a non-price variable will result in a shift in the demand curve.
An outward shift in demand will occur if income increases, in the case of a normal good;
however, for an inferior good, the demand curve will shift inward noting that the consumer
only purchases the good as a result of an income constraint on the purchase of a preferred
good.
Quantity supplied moves in the same direction as price.
The supply curve is an upward sloping curve.
Producers are willing to increase production at higher prices to increase profit.
The supply curve plots the quantity that is willingly supplied at any given price.
The individual supply curves can be summed by quantity provided at a specific price to
achieve an aggregate supply curve.
The supply curve is upward sloping in the short run.
Supply is the quantity of a good or service that a supplier provides to the market.
Suppliers will shift production for non- price changes related to the determinants of supply
and will slide production levels across the supply curve for price related movements.
and will result in a shift in supply; supply will shift outward if costs decrease and will shift
inward if they increase.
A change in the expected demand for a good or service will result in a shift in supply; supply
will shift outward if enthusiasm is expected to increase and will shift inward if there is an
expectation for consumers preferences to change in favor of an alternate good or service.
The interdependent relationship between supply and demand in the field of economics is
inherently designed to identify the ideal price and quantity of a given product or service in a
marketplace.
A market clearing, by definition, is the economic assumption that the quantity supplied will
consistently align with the quantity demanded.

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Market clearing requires a variety of assumptions which simplify the complexities of real
markets to coincide with a more theoretical framework, most centrally the assumptions of
perfect competition and Say’s Law.
While this concept of market clearing resonates well in theory, the actual execution of
markets is very rarely perfect. The concepts of consolidated markets and ‘sticky’ markets
reduces the accuracy of these models.
The interdependent relationship between the supply of a given product or service and the
overall demand exercised by interested parties generates a theoretical equilibrium point,
dictating the average market price and purchase volume relative to that price.
Markets are in constant flux as demands and supplies are subjected to varying driving forces
and influences. These shifts play a critical role, altering market equilibrium price points and
volumes for products and services.
Demand shifts can be caused by a wide variety of factors, but largely revolve around drivers
of consumer behavior and circumstances.
Supply shifts, similar to demand shifts, can ultimately be a result of a wide variety of
externalities. Scarcity, or the lack of availability for a particular material, is a core driving force
for overall supply.
Due to a demand curve ‘s sloping downward and a supply curve ‘s sloping upwards, the curves
will eventually cross at some point on any supply/demand chart. This point of equilibrium
serves as a price and quantity tracking point.
Surpluses, or excess supply, essentially indicates that the quantity of a good or service
exceeds the demand for that particular good at the price in which the producers would wish
to sell ( equilibrium level).
In a perfectly competitive market, excess supply is equivalent to the quantity available in the
market beyond the equilibrium point of intersection between supply and demand. This will
result in a shift in market equilibrium towards lower price points.
Shortage is a term used to indicate that the supply produced is below that of the quantity
being demanded by the consumers. This disparity implies that the current market equilibrium
at a given price is unfit for the current supply and demand relationship.
In a perfectly competitive market, a shortage in supply will ultimately result in a shift in the
equilibrium point, transitioning towards a higher price point due to the limited supply
availability.
Prolonged shortages caused by price ceilings can create black markets for that good.
For a price floor to be affect the market, it must be greater than the free-market equilibrium
price.
Price floors above the equilibrium price will induce a surplus.
Unit 4
Demand is the willingness and ability of a consumer to purchase a good under certain
circumstances.
Demand curves are used to estimate behaviors in competitive markets and are often used
with supply curves to estimate the market equilibrium price, or the price at which sellers are
willing to sell the same amount of a product as the market’s buyers are willing purchase.
An individual’s demand is defined by her utility, purchasing power, and ability to make a
purchasing decision.

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On a supply and demand chart, consumer surplus is bound by the y-axis on the left, the
demand curve on the right, and a horizontal line where y equals the current market price.
Another way to define consumer surplus in less quantitative terms is as a measure of a
consumer’s well-being.
An individual’s customer surplus for a product is based on the individual’s utility of that
product.
Consumer surplus will only increase as long as the benefit from the lower price exceeds the
costs from the resulting shortage.
Consumer surplus always decreases when a binding price floor is instituted in a market above
the equilibrium price.
The total economic surplus equals the sum of the consumer and producer surpluses.
Price helps define consumer surplus, but overall surplus is maximized when the price is pareto
optimal, or at equilibrium.
Firms with market power are said to be “price makers.” They can raise prices and change the
quantity supplied of goods and services without hurting profits. Market power often exists
when there is a monopoly or oligopoly.

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