The Consumer Welfare and the Producer Surplus - Coursework Example

Principles of Economics Number March 31, Faculty Principles of Economics There are two quantities of economic welfare. These are the consumer welfare and the Producer surplus. The concept of the economic surplus was introduced to address the novel complexities caused by the dominance of monopoly capital. The importance of this concept and its consistency with the Marx’s labour concept of surplus value cannot be undermined in economics (Hirschey, 2009). Consumer surplus is the gain obtained by paying a price that is less than the highest price buyers are willing to pay (Tucker, 2013). In a standard linear demand –supply diagram, consumer surplus is the triangular area above the equilibrium price of the product and below the demand curve. The concept demonstrates that consumers would have been willing to purchase a single unit of a product at a higher price than the equilibrium price. The buyer would be willing to pay a price higher than the equilibrium price but below the price paid for the first commodity. However, the consumers acquire every unit of the products at the equilibrium price. The benefit obtained from the purchased product exceeds the initial pay for the same product. Taking an example of drinking water, one would be willing to pay much higher prices for a single unit of water as they need water for survival. The difference between the actual prices paid to acquire a unit of water, and the prices that would be paid if the demand had exceeded the supply of water is consumer surplus. The utility of the first few units of drinking water would thus be higher. Thus, they would contribute a higher consumer surplus than subsequent units of the same commodity. The prices adopt a diminishing trend (MacEachern, 2009). For every given price, the consumers buy the quantity for which the consumer surplus is the highest (Mankiw, 2008). Consumer surplus is highest for the largest number of product units for which, even the last unit, the market price is less than the maximum willingness to pay. The sum of all individual consumer surpluses is the aggregate consumer surplus. A graphical illustration of consumer surplus and the producer surplus is given below. Consumer surplus: (Mankiw, 2012) Consumer surplus declines with consumption in line with the law of diminishing marginal utility. In the earlier example, a thirsty person would be willing to pay a relatively high price for the first unit of cold water. However, as they drink more, the lesser utility will be derived from subsequent units and hence the consumer would consider paying a lower price for those units. Prices of commodities fall with the increase in the supply and hence consumer surplus increases. The reduction in price confers a price benefit to the consumers who were initially paying more for the product as they can buy more at the initial cost. Similarly, additional customers who were not willing to buy at the initial price can buy at the reduced prices and hence utilising consumer surplus (Mankiw, 2012). Producer Surplus Producer surplus refers to the amount of benefit obtained by producers by selling at a price higher than the least price they would be willing to receive age of their goods or services (Marshall and Kalos, 2008). The concept of producer surplus illustrates profit since producers are not willing to sell at a loss. Diagrammatically, producer surplus can be represented as shown below.   Producer Surplus: (McEachern, 2009) The area marked producer surplus above the producer’s supply curve represents the amount of benefits producers receive by selling at price P (i). The increase in the size of this area would increase the amount of producer surplus. Ideally, when the demand for goods in the market increases, the prices also increase. Buyers are forced to pay an additional price for the same products than before. Producers can obtain an extra economic benefit represented by the difference between the initial and new prices for goods. Therefore, producer surplus increases with the increase in price holding other factors constant (Tsiakis, Kargidis and Katsaros, 2014). For example, assume that in a market, the producer is willing to sell 500 loaves of bread at $5 per piece. Imagine that the consumers were willing to pay $8 per loaf of bread. If the producer sells all the bread to the customers at $5 per loaf, the producer will receive sales revenue of $4000. However, if the producer sold all the 500 loaves at $5 per loaf, they would get an income of $2500. Producer surplus can be calculated by subtracting $2500 from $4000 to get an excess of $1500 to the producer. The diagram below illustrates a further explanation of the producer surplus (Tucker, 2013). Producer Surplus: (Tucker, 2013) Pm is the lowest price at which the producer would be willing to sell at the market. Production expands along the supply curve to the right. When the market reaches equilibrium at quantity Q1 and price P1, the level of producer surplus would be as shown in the shaded region. The Total Revenue=Price per unit multiplied by the quantity sold (McEachern, 2009). Producer and Consumer Surplus combined The concept of consumer and producer surplus can be merged (Mankiw, 2012). The diagram below represents producer and consumer surplus. Consumer surplus: (Mankiw, 2012) Consumer surplus (red) arises when consumers purchase the product at the equilibrium price. The equilibrium price represents the least amount for which the producer would be willing to sell the products at the market. The consumers in the above case are willing to pay a higher price per unit of product represented by the demand curve’s intersection point with Y-Axis. Producers opt to sell commodities at the equilibrium price when the supply of goods exceeds demand pushing the prices down (Mankiw, 2012). Under the concept of producer surplus (blue), the equilibrium price is assumed the highest price that buyers are willing to pay. The supply curve and the Y-Axis (price) intersection represent the least price at which producers would sell. Selling the products at the highest price may result from a decline in supply pushing the prices upwards (Mankiw, 2012). Producer and consumer surplus are inversely related. An increase in one would lead to a decrease in the other. There is a trade-off between the two concepts in that when the economic welfare of either group is optimum that of the other group is at the minimum level (Hirschey, 2009). Deadweight Loss Excessive burden and allocative inefficiency are terms used interchangeably with a deadweight loss in economics. They both refer to a loss of economic efficiency when the market equilibrium of a service or product is not achieved. A number of factors can cause deadweight loss. These range from externalities, binding price ceilings and floors, taxes and subsidies to monopoly pricing (Carbaugh, 2009). Taking an example, we consider a market for knives where each knife costs $1 with the demand decreasing linearly from a high demand free knives to zero demand for knives at $11. The producers have to charge $1 in a competitive market. Every customer whose marginal benefit exceeds $1 would buy a knife. However, if there is a monopolist producer, they will charge a price that yields the greatest profit. For this market, the producer would sell at $6 and hence exclude every customer who had less than $6 of marginal benefit. A deadweight loss would then be the economic benefit foregone by these customers due to monopoly pricing (Marshall and Kalos, 2008). Deadweight loss can also occur when consumers buy goods, which cost more than they benefit them (Tsiakis, Kargidis and Katsaros, 2014). In the case of knives, we assume that the market is perfectly competitive and that the government induces a 30 cents subsidy for each knife. The subsidy would push the market price of each knife down to 70 cents. Customers would buy knives even though the benefit is less than the real cost of $1. Resources are not used efficiently and the result of is deadweight loss. Likewise, when the government levies tax on a commodity, the burden of tax raises the price. A number of consumers who afforded the product initially have to seek alternative products whose benefit matches the cost. The excess burden of taxation translates to loss of utility to the consumer seeking alternative products. The diagram below illustrates the deadweight loss. Deadweight loss: (Tucker, 2013) The diagram shows a deadweight loss created by a price ceiling. The ceiling sets the maximum price for which producers may charge for a product. Producer surplus decreases while consumer surplus may or may not increase. The increase in consumer surplus must be less than the decrease in producer surplus for deadweight loss to occur (Carbaugh, 2009). Conclusion The terms consumer surplus, producer surplus and deadweight loss are of importance to business managers. In their allocative roles, these managers should apply equity and efficiency in their systems of production. Thorough knowledge of the critical terms for business managers would ensure that they efficiently run the enterprises and deliver equitably to their customers (Hirschey, 2009). References Carbaugh, R. (2009). International economics. Mason, Ohio: South-Western Cengage Learning. Hirschey, M. (2009). Fundamentals of managerial economics. Mason, OH: South-Western/Cengage Learning. MacEachern, W. (2009). Economics. Mason, Ohio: South-Western. Mankiw, N. (2008). Principles of macroeconomics. Mankiw, N. (2012). Essentials of economics. Australia: South-Western Cengage Learning. Mankiw, N. (2012). Principles of economics. Mason, OH: South-Western Cengage Learning. Marshall, K. and Kalos, S. (2008). The economics of antitrust injury and firm-specific damages. Tucson, AZ: Lawyers & Judges Pub. Co. McEachern, W. (2009). Economics. Mason, OH: South-Western Cengage Learning. Tsiakis, T., Kargidis, T. and Katsaros, P. (2014). Approaches and processes for managing the economics of information systems. Tucker, I. (2013). Macroeconomics for today. Mason, Ohio: South-Western. ` Read More