$2.50

$2.00

Price

Frozen pizzasper week

$3.00

$3.50

MB4 MB3 MB2 MB1<<<MU4 MU3 MU2 MU1<<<

because

d MB=

• The demand for frozen pizzas reflects the law of diminishing marginal utility.• Because marginal utility (MU) falls with increased consumption, so does a consumer’s maximum willingness to pay -- marginal benefit (MB).• A consumer will purchase until MB = Price . . . so at $2.50 they would purchase 3 frozen pizzas and receive a consumer surplus shown by the shaded area (above the price line and below the demand curve).

Price =$2.50

The Pizza Demand Curve

John’s demand curvefor frozen pizza

421 3

MB

4

MB

3

MB

2

MB

1

Consumer SurplusThe total difference between what a consumer is willing to pay and how much they actually have to pay.

Producer SurplusThe total difference between what a supplier is willing to provide a good or service and how much they actually get for it.

Consumer surplus measures the net benefit to consumers from participating in a market rather than the total benefit.

Consumer surplus in a market is equal to the total benefit received by consumers minus the total amount they must pay to buy the good or service.

Similarly, producer surplus measures the net benefit received by producers from participating in a market.

Producer surplus in a market is equal to the total amount firms receive from consumers minus the cost of producing the good or service.

What Consumer Surplus and Producer Surplus Measure

S

D

P

Q

Consumer surplus = area of blue triangle =

½($5)(5) = $12.5

Producer surplus = area of red triangle =

½($5)(5) = $12.5

Producer and Consumer Surplus

The combination of producer and consumer surplus is maximized at

market equilibrium

CS

PS

$10987654321

0 1 2 3 4 5 6 7 8

Marginal Cost to Producer equals Marginal Benefit to Consumers

S

D

P

Q

At Q = 3, consumers want more, and producers want

to supply more

At Q = 8, consumers want less and producers are willing to supply less.

Inefficiency

Only at equilibrium are producer and consumer

surplus maximized.

CS

PS

$10987654321

0 1 2 3 4 5 6 7 8

Economic surplus is maximized when a market is in competitive equilibrium. When a market is not in equilibrium, there is a deadweight loss. When the price of chai tea is $2.20 instead of $2.00, consumer surplus declines from an amount equal to the sum of areas A, B, and C to just area A. Producer surplus increases from the sum of areas D and E to the sum of areas B and D.At competitive equilibrium, there is no deadweight loss. At a price of $2.20, there is a deadweight loss equal to the sum of areas C and E.

Deadweight loss is the reduction in economic surplus resulting from a market not being in competitive equilibrium.

Consumer Surplus

Price Quantity 5 1 6 27 38 49 5

If the selling price is 3, the consumer surplus for the 1st item is 5-3=2, plus 4-3=1 for the 2nd and 3-3=0 for the

3rd, or 3

1st 2nd

3rd

4th

Government Intervention in the Market:

Price Controls

• Price floor is a legally established minimum price that buyers must pay.

• It stops the price from dropping down to equilibrium level.

• Example: minimum wage• The direct effect of a price floor above the

equilibrium price is a surplus: quantity supplied exceeds quantity demanded.

1. Price Floors

• A price floor like P1 sets a price above market equilibriumcausing quantity supplied

QD …

•Non-price factors will become more important than

prices in determining where scarce

goods go.

to exceed quantity demanded

QS … resulting in a surplus.

The Impact of a Price FloorPrice

Quantity

Pricefloor

D

QD QS

P0

SP1

Surplus

• Direct effect: • Reduces employment of low-skilled

labor.• Indirect effects:

• Reduction in non-wage component of compensation.

• Less on-the-job training.• May encourage students to drop out of

school• A higher minimum wage does little to

help the poor.

Minimum Wage Effects

Employment and the Minimum WagePrice (wage)

Quantity(employment)

Minimum wage level

D

E1 E0

S

$ 5.15

Excesssupply

$ 4.00

• If a price (wage) of $4.00 could bring equilibrium.

• A minimum wage (price floor) of $5.15 would increase the earnings of those who stayed employed (E1), but would reduce the employment of others.

• Those who lose their job (E0 to E1) would be pushed into either unemployment or some other less preferred form of employment.

• It stops the price from rising to the equilibrium level.

• Example: rent control• The direct effect of a price ceiling is a

shortage: quantity demanded exceeds quantity supplied.

2. Price Ceilings

• Price ceiling is a legally established maximum price that sellers may charge.

• In the rental housing market the price (rent) P0 would bring the quantity of rental units demanded into balance with the quantity supplied.

• A price ceiling like P1sets a price below equilibrium …

quantity demanded QD …

exceeds quantity supplied QS … resulting in a shortage.

The Impact of a Price CeilingPrice(rent)

Quantity of housing units

Priceceiling

D

QS QD

P0

S

P1

Shortage

Rental housing market

• The future supply of housing will decline.• The quality of housing will deteriorate.• Non-price methods of rationing will

increase in importance.

Effects of Rent Control

• Long-term renters will benefit at the expense of newcomers.

The Impact of a Tax

Tax Incidence

• Who pays a tax is called the incidence.Buyer

Seller

Price

# of used carsper month(in thousands)

D

500 750

$6,400

S plus tax

$7,000

$7,400

S

$1000 tax

Impact of a Tax Imposed on Sellers

• If in the used car market a price of $7,000 would bring the

quantity of used cars demanded into balance with the quantity

supplied.

• When a $1,000 tax is imposed on sellers of used cars, the supply curve shifts vertically by the amount of the tax.• The new price for used cars is $7,400 …

• Consumers end up paying $7,400 instead of $7,000 and bear $400 of the tax burden. • Sellers end up receiving $6,400 (after taxes) instead of $7000 and bear $600 of the tax burden.

sellers netting $6,400 ($7,400 - $1000 tax).

Price

# of used carsper month(in thousands)

D

500 750

$6,400

$7,000

$7,400

S

$1000 tax

Impact of a Tax Imposed on Buyers

• In the same used car market:

• When a $1,000 tax is imposed on buyers of used cars, the demand curve shifts vertically by the amount of the tax.

• The new price for used cars is $6,400 …

• Consumers end up paying $7,400 (after taxes) instead of $7,000 and bear $400 of the tax burden. • Sellers end up receiving $6,400 instead of $7000 and bear $600 of the tax burden.

buyers then pay taxes of $1000 making the total $7,400.

D minus tax

• The actual burden of a tax depends on the elasticity of supply and demand.• As supply becomes more inelastic,

then more of the burden will fall on sellers.• As demand becomes more inelastic,

then more of the burden will fall on buyers.

Elasticity and Incidence of a Tax

110

D

Luxury boatmarket

194

80

Gasolinemarket

S

$1.60

$1.50$1.45

Quantity(thousands

of boats)

Quantity(millions of gallons)

Price

Price(thousand $)

Tax Burden and Elasticity

90

100

5 10 15 20

D

S plus tax

200

$1.55

$1.65S

S plus tax• Consider the market for Gasoline and Luxury Boats individually.

• In the gas market, the demand is relatively more inelastic than its supply; hence, buyers bear a larger share of the burden of the tax.• In the luxury boats market, the supply curve is relatively more inelastic than its demand; hence, sellers bear a larger share of the tax burden.

• We begin in equilibrium.• If we impose a $.20 tax on gasoline suppliers, the supply curve moves vertically the amount of the tax. Price goes up $.15 and output falls by 6 million gallons per week.• If we impose a $25K tax on Luxury Boat suppliers, the supply curve moves vertically the amount of the tax. Price goes up by $5K and output falls by 5 thousand units.

1. Which of the following is a major disadvantage of setting the price of a good below equilibrium and using waiting in line rather than price to ration the good?a. Compared to price rationing, waiting in line is unfair since it is easier for those with higher incomes to wait in line.b. Waiting in line imposes a cost on the consumer; paying higher prices does not.c. Both waiting in line and higher prices are costly to consumers, but unlike the payment of a higher price, waiting in line does not provide suppliers with an incentive to expand future output.d. Waiting in line benefits consumers at the expense of producers.

2. When a price floor is above the equilibrium price,a. quantity demanded will exceed quantity

supplied, so there will be a shortage.b. quantity supplied will exceed quantity

demanded, so there will be a surplus.c. the market will be in equilibrium.d. This is a trick question because price floors

are generally set below the equilibrium price.

3. Rent control applies to about two-thirds of the private rental housing in New York City. Economic theory suggests that the below-equilibrium prices established by rent controls would

a.create a surplus of rental housing.b. promote a rapid increase in the future supply

of housing.c.result in poor service and quality deterioration

of many rental units.d. lead to a reduction in housing discrimination

against minorities.

4. Which of the following is the most likely result of an increase in the minimum wage?

a.an increase in the employment of unskilled workers

b. a decrease in the number of workers seeking minimum wage jobs

c.an increase in the demand for unskilled workersd. a decrease in the employment of unskilled

workers

5. The benefit of a subsidy will go primarily to sellers when the

a. demand for the product is highly inelastic and supply is relatively elastic.

b. demand for the product is highly elastic and the supply is relatively inelastic.

c. subsidy is legally (statutorily) granted to the seller of the product.

d. subsidy is legally (statutorily) granted to the buyer of the product.

6. If there was an increase in the excise tax imposed on beer suppliers, what would be the effect on the equilibrium price and quantity of beer?

a. price increases; quantity decreasesb. price decreases; quantity decreasesc. price increases; quantity increasesd. price decreases; quantity increases

7. The more elastic the supply of a product, the more likely it is that thea. burden of a tax on the product will fall on sellers.b. burden of a tax on the product will fall on buyers.c. burden of a tax on the product will fall equally on both buyers and sellers.d. deadweight loss of the tax will be smaller.