[email protected] » Consumer and Producer Surplus MAKING GAINS BY THE BOOK TERE IS A LIVELY MARKET IN SECOND-HAND college textbooks. At the end of each term, some students who took a course decide that the money they can make by selling their used books is worth more to them than keeping the books. And some students who are taking the course next term prefer to buy a somewhat battered but less expensive used textbook rather than pay full price for a new one. from being able to purchase a good-known as consumer surplus. And we will see that there is a corresponding measure, producer surplus, of the benefits sellers receive from being able to sell a good. The concepts of consumer surplus and producer sur-plus are extremely useful for analyzing a wide variety of economic issues. They let us calculate how much benefit producers and consumers receive from the existence of a Textbook publishers and authors are not happy about these transactions, because they cut into sales of new books. But both the students who sell used books and those who buy them clearly benefit from the existence of the market. That is why many college bookstores facilitate their trade, buying used text-books and selling them , _________ ..L _________ -, market. They also allow us How much am I willing to pay for that used textbook? to calculate how the wel-fare of consumers and pro-ducers is affected by changes in market prices. Such calculations play a crucial role in evaluating many economic policies. What information do we need to calculate con-sumer and producer sur-plus? Surprisingly, all we need are the demand and alongside the new books. supply culVes for a good. But can we put a number on what used textbook buy- That is, the supply and demand model isn't just a model ers and sellers gain from these transactions? Can we of how a competitive market works-it's also a model of answer the question, "How much do the buyers and sell-how much consumers and producers gain from partici-ers of textbooks gain from the existence of the used-book pating in that market. So our first step will be to learn market?" how consumer and producer surplus can be derived from Yes, we can. In this chapter we will see how to meas-the demand and supply culVes. We will then see how ure benefits, such as those to buyers of used textbooks, these concepts can be applied to actual economic issues. Printed by Edward Morey Copyright 2009 Worth94 P A RT 2 [email protected] SUPPLY AND DEMAND WHAT YOU WIll LEARN IN THIS CHAPTER: ~The meaning of consumer surplus and its relationship to the demand curve ~The meaning of produce r surplus and its relationship to the supply curve ~The meaning and importance of total surplus and how it can be used both to measure the gains from trade and to illustrate why markets work so well ~ The critical importance of property rights and prices as economic signals to the smooth functioning of a market ~Why markets typically lead to effic;ent outcomes and why markets sometimes fail A consumer's w illingness to pay for a good is the maximum price at which he or she would buy that good. Consumer Surplus and the Demand Curve The market in used textbooks is a big business in terms of dollars and cents- approx-imately $1.9 billion in 2004-2005. More importantly for us, it is a convenient start-ing point for developing the concepts of consumer and producer surplus. We'll use the concepts of consumer and producer surplus to understand exactly how buyers and sellers benefit from a competitive market and how big those benefits are. In addi-tion, these concepts play important roles in analyzing what happens when competi-tive markets don't work well or there is interference in the market. So let's begin by looking at the market for used textbooks, starting with the buy-ers. The key point, as we'll see in a minute, is that the demand curve is derived from their tastes or preferences-and that those same preferences also determine how much they gain from the opportunity to buy used books. Willingness to Pay and the Demand Curve A used book is not as good as a new book-it will be battered and coffee4stained, may include someone else's highlighting, and may not be completely up to date. How much this bothers you depends on your preferences. Some potential buyers would prefer to buy the used book even if it is only slightly cheaper than a new one, while others would buy the used book only if it is considerably cheaper. Let's define a potential buyer's willingness to pay as the maximum price at which he or she would buy a good, in this case a used textbook. An individual won't buy the good if it costs more than this amount but is eager to do so if it costs less. If the price is just equal to an individual's willingness to pay, he or she is indifferent between buying and not buying. For the sake of simplicity, we'll assume that the individual buys the good in this case. The table in Figure 4-1 shows five potential buyers of a used book that costs $100 new, listed in order of their willingness to pay. At one extreme is Aleisha, who will buy a second-hand book even ifthe price is as high as $59. Brad is less willing to have a used book and will buy one only if the price is $45 or less. Claudia is willing to pay only $35 and Darren, only $25. And Edwina, who really doesn't like the idea of a used book, will buy one only if it costs no more than $10. How many of these five students will actually buy a used book? [t depends on the price. If the price of a used book is $55, only Aleisha buys one; if the price is 540, Aleisha and Brad both buy used books, and so on. So the information in the table can be used to construct the demand schedule for used textbooks. As we saw in Chapter 3, we can use this demand schedule to derive the market demand curve shown in Figure 4-1. Because we are considering only a small number of consumers, this curve doesn't look like the smooth demand curves of Chapter 3, where markets contained hundreds or thousands of consumers. This demand curve is step-shaped, with alternating horizontal and vertical segments. Each horizontal segment-each step-corresponds to one potential buyer's willingness to pay. However, we'll see shortly that for the analySiS of consumer surplus it doesn't matter whether the demand curve is step-shaped,