Using Supply and Demand To Analyze Markets: Chapter Outline 3.1 Consumer and Producer Surplus

Using Supply and
Demand to Analyze Markets 3

Chapter Outline
3.1 Consumer and Producer Surplus:
Who Benefits in a Market?
3.2 Price Regulations
3.3 Quantity Regulations
3.4 Taxes
3.5 Subsidies
3.6 Conclusion
Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e 3-1
Introduction 3
In this chapter, we use the supply and demand model to
answer the following questions
• How do we measure the benefits that accrue to
producers and consumers in a market?
• How do government interventions (e.g., taxes) affect
markets and the benefits associated with market
exchange?
3.1
Consumer and Producer Surplus:
Who Benefits in a Market? 3
Consumers benefit from market exchange, otherwise they would
not participate
• Consumer surplus – The difference between the amount
consumers would be willing to pay for a good or service and the
amount they actually pay (the market price)
In many cases, this difference is positive, and consumers
experience net benefits from market exchange
3.1
Figure 3.1 Defining Consumer Surplus
Price ($/pound) Demand
choke price
$5.50 A Total consumer
5 surplus (CS)
Person A’s B
4.50
consumer C
surplus = $1.50 4 D
3.50 Market price
3 E
D
2 The consumer at point E will
not buy any apples because the
1 market price is too high
0 1 2 3 4 5 Quantity of
apples (pounds)
3.1
Producers benefit from market exchange, otherwise they would
not participate
• Producer surplus – The difference between the amount
producers are willing to sell goods for and what they actually
receive (the market price)
Producer surplus is not the same as profit, as we will see in later
chapters
3.1
Figure 3.2 Defining Producer Surplus
The producer at point Z will not
Price ($/pound) produce any apples because the
Total producer market price is too low
5
surplus (PS) S
4
Z
3.50 Market price
Seller V ’s Y
producer 3
X
surplus = $1.50 2.50
2 W
V
1.50
1 Supply
choke price
0 1 2 3 4 5 Quantity of
apples (pounds)
The Market for Cupcakes figure it out
The weekly supply and demand for cupcakes in a small town are
given as
QS = 30P – 20 , QD = 124 – 18P
where P is the price, in dollars, and quantity is measured in
thousands of cupcakes per week
Answer the following questions:
1. Find the equilibrium price and quantity
2. Calculate consumer and producer surplus at the equilibrium
1. Remember: Equilibrium is characterized by QS = QD

30P – 20 = 124 – 18P
Combining terms and solving for P yields
48P = 144 → P* = $3
And using the equation for demand,
QD = 124 – 18(3) = 70 = Q* = QS
2. The easiest way to calculate consumer and producer surplus is with a
graph; to do this, we must determine two points for each curve
• Equilibrium price/quantity
• Choke prices (where QD /QS are equal to zero)
Why do we need only two points to plot the demand/supply curves?
We already know one point for each curve: P* = $3.00 ; Q* = 70
Demand choke price: QD = 0 = 124 – 18P → P = $6.89
Supply choke price: QS = 0 = 30P – 20 → P = $0.67
Price of cupcakes
Consumer surplus is the area below demand
(dollars)
but above the price (Area A)
6.9 1
CS  Area A   base  height
2
1
  70  (6.89  3)  $136.15
S 2
A Producer surplus is the area above supply
but below the price (Area B)
3 1
PS  Area B   base  height
B 2
1
  70  (3  0.67)  $81.55
2
0.67 D Surplus is generally measured in dollars
0 70 Quantity of cupcakes
(thousands)
3.1
What happens to consumer and producer surplus when there is a shift in supply or
demand?
Imagine a pie shop opens up in the same town. What
will happen to the demand for cupcakes?
Price of cupcakes
(dollars) Demand will shift left, resulting in a new
equilibrium of P2 andQ2
What happens to consumer surplus?
E • Old consumer surplus: A + B + F
A S • New consumer surplus: B + C
What happens to producer surplus?

B F • Old producer surplus: C + D + E + G
P1 G • New producer surplus: D
C
P2
D C has transferred from producers to consumers
A + E + F + G has disappeared from this market
D2 D1
0 Q2 Q1 Quantity of cupcakes
(thousands)
3.1
Figure 3.3 Consumer Surplus and the Elasticity of Demand
The Market for Tires figure it out
The weekly supply and demand for tires in a small town are given as
QS = 15P – 400 , QD = 2,800 – 25P
where P is the price, in dollars, and quantity is the number of tires sold
weekly. The equilibrium price is $80 per tire, and 800 tires are sold each
week
Suppose an improvement in technology makes tires cheaper to produce;
specifically, suppose the quantity supplied rises by 200 at every price
1. What is the new supply curve?
2. What are the new equilibrium price and quantity?
3. What happens to consumer and producer surplus?



3.1
Figure 3.5 Changes in Surplus from a Supply Shift
3.2 Price Regulations 3
Politicians often call for the direct regulation of prices on products
and services
• Price ceiling – a regulation that sets the maximum price that can be
legally paid for a good or service
• Price floor – a regulation that sets the minimum price that can be
legally paid for a good or service (often called a price support)
What are the effects of price ceilings/floors on markets?
Some important terminology
Transfer – surplus that moves from producers to consumers, or vice versa,
as a result of a regulation
Deadweight loss (DWL) – the reduction in total surplus that occurs as a
result of a market inefficiency
• Remember the cupcake example of changing demand due to a pie shop
Nonbinding price ceiling – a price set at a level above the equilibrium

market price
Nonbinding price floor – a price set at a level below the equilibrium
market price
3
Figure 3.7 The Effects of a Price Ceiling
Price
Consumer surplus before A+B+C
($/pizza)
Consumer surplus after A+B+D
$20 Producer surplus before D+E+F
Producer surplus after F
A z DWL = C + E Supply
14
B w
C
10 y
D E
8 x
F
5
Transfer
of PS Demand
to CS
0 6 10 12 20 Quantity of pizzas
(thousands)/month
Shortage
3.8 Deadweight Loss and Elasticities
3
Figure 3.9 The Effects of a Price Floor
Price
($/per ton) Transfer
of CS to PS S
A x y Price floor
$1,000
B w Consumer surplus before A+B+C
C
500 Consumer surplus after A
D E Producer surplus before D+E+F
Producer surplus after B+D+F
z
F
0 10 20 30 Quantity of peanuts
(millions of tons)
Surplus
3.3 Quantity Regulations 3
Like price regulations, quantity regulations restrict the amount of
a good or service provided to a market
Quota – a regulation that sets the quantity of a good or service
provided
• Often used to limit imports of certain goods; why might a government
pursue an import quota?
• Sometimes used to limit exports (e.g., China and rare earths)
What are the effects of quotas on markets?
3.3 Quantity Regulations
3
Figure 3.10 The Effects of a Quota
Price
Consumer surplus before A+B+C
($/tattoo)
S2 Consumer surplus after A
$125 Producer surplus before D+E+F
Producer surplus after B+D+F
A z
Pquota = 100
Transfer
of CS to PS
B
C
x S1
P = 50
D E
40
35
y D
F
0 500 1,500 Quantity of

(Quota) tattoos/year
3.3 Quantity Regulations 3
Government provision of a public good: municipal golf courses
Sometimes, governments attempt to supplement market
Price of a golf supply for things that benefit communities
round
What happens to the market for golf when a local
Spriv government opens a municipal course?
• With only for-profit and private courses, supply is Spriv and
the market equilibrium occurs at Q1 and P1
Stot • The municipal course increases the quantity of rounds
P1 available by Qgov , and supply shifts out to Stot
Ptot However, quantity supplied only increases to Qtot because

private suppliers are not willing to supply as much at the
new, lower market price
• Private producers reduce quantity supplied to Qpriv , this effect
D is known as “crowding out”
0 Qpriv Q1 Qtot Q1 + Qgov Quantity of rounds
Crowding out
3.4 Taxes 3
Taxes are very prevalent in societies
• Product markets (VAT; sales taxes)
• Labor markets (income taxes; payroll taxes)
• Capital markets (capital gains taxes)
How do taxes impact markets?
• Some taxes are imposed to correct market failures (see Chapter 16)
• In general, taxes distort market outcomes
• How do we describe the effects of taxes?
Example: In 2003, Boston’s Mayor Tom Menino proposed a $0.50 tax
on movie tickets
• How should this tax (which was ultimately not adopted by the legislature)
affect the market for movie tickets?
3.4 Taxes 3
Figure 3.13 The Effects of a Tax on Boston Movie Tickets
Price
($/ticket)
$10
Transfer from CS and PS
to government
S2 = S1 + tax
A
y
Pb = 8.30 C S1
B x
P1 = 8.00
D D
Ps = 7.80 z E Consumer surplus (CS) before A+B+C
F Consumer surplus (CS) after A
Producer surplus (PS) before D+E+F
Producer surplus (PS) after F
6.67 Government revenue B+D
0 Q2 = 3.4 Q1 = 4 Quantity of tickets

(100,000s)
3.4 Taxes 3
We can also describe the effect of a tax on consumer and producer surplus with
equations. Demand and supply for tickets are given by
Q D  20  2 P; Q S  3P  20
where prices are measured in dollars and quantity in hundreds of thousands of
tickets. Equilibrium occurs when QD = QS,
20  2 P  3P  20  5P  40
Before the tax, tickets are $8 and 400,000 tickets are sold in Boston
Pre-tax consumer surplus
1
CS   Q   PDChoke  P1 
2
where the demand choke price is found by solving
Q D  0  20  2 PDChoke  PDChoke  $10 CS  1   400,000   $10  $8  $400,000

and consumer surplus is equal to 2
3.4 Taxes 3
Pre-tax producer surplus surplus
1
PS   Q   P1  PSChoke 
2
where the supply choke price
Q S  0  3PSChoke  20  PSChoke  $6.67
Solving for producer surplus yields

1
PS    400,000   $8  $6.67   $266,667
2
PS  CS  $666,667
And total surplus
What happens after the tax?
3.4 Taxes 3
Define the after-tax price as
Pb  PS  $0.50
The market price (the price buyers pay), Pb , is equal to the price the producer
received, PS , plus the tax. To find the new equilibrium, substitute this
expression intoS the demand equation
Q  Q  20  2 Pb  3PS  20  20  2 PS  0.50  3PS  20
D
 Why do we not substitute into the supply equation?

20  2 PS  1  3PS  20  PS  $7.80
Solving for PS
The new market price is Pb  PS  $0.50  $8.30
and quantity (substitute

Q  buyer
20 price
2 8.30into demand
  340,000 function)
2
3.4 Taxes 3
New consumer surplus
1
CS    340,000   $10  $8.30  $289,000
2
and producer surplus
1
PS    340,000   $7.80  $6.67   $192,100
2
How much revenue has been generated by the tax?

Revenue  0.50Q2  $0.50  340,000  $170,000
And the associated deadweight loss associated with this distortion is

tax
1     1
DWL    Q1  Q2    Pb  Ps     400,000  340,000   $0.50  $15,000
2 2
3.4 Taxes 3
Deadweight loss (DWL) is the loss in total surplus generated any time
a policy creates a market distortion
• DWL associated with taxes is often referred to as “excess burden”
• The size of DWL increases at an increasing rate with the difference
between the pre- and post-policy equilibrium quantities
• Big taxes create more DWL than little taxes
Consider the movie example, but with a $1.00 tax
Pb  PS  $1.00
Q D  Q S  20  2 Pb  3PS  20  20  2 PS  1.00  3PS  20

Solving for PS , Pb , and Q2
20  2 PS  2  3PS  20  PS  $7.60; Pb  $8.60
Q2  20  2 8.60  2.8
3.4 Taxes 3
1
Consumer surplus CS    280,000   $10  $8.60  $196,000
2
1
PS    280,000   $7.60  $6.67  $130,200
and producer surplus 2
How much revenue has been generated by the tax?

Revenue  1.00Q2  $1.00  280,000  $280,000
And the associated deadweight

tax
loss associated with this distortion is
1    1
DWL    Q1  Q2    Pb  Ps     400,000  280,000   $1.00  $60,000
2 2
So, while the tax rate has doubled, deadweight loss has quadrupled from
$15,000 to $60,000, and tax revenues have only increased by 78.5% (from
$170,000 to $280,000)
3.4 Taxes 3
Figure 3.14 The Effect of a Larger Tax on Boston Movie Tickets
3.4 Taxes 3
Tax incidence is a term describing who actually bears the burden of a
tax
• In the supply and demand model, it does not matter who is required to pay
the tax (e.g., a sales tax vs. a production tax); tax incidence will be the same
in each case!
• Consider again the movie theater example
3.4 Taxes 3
Figure 3.15 Tax Incidence
(a) (b)
Price ($) Price ($)

S2
Tax = Pb – Ps
S1 S
Pb Pb
P1 P1
Ps Ps
D D1
D2
Tax = Pb – Ps
0 Quantity 0 Q2 Q1 Quantity
Q2 Q1
3.4 Taxes 3
Tax incidence is a term describing who actually bears the burden of a tax
• In the simple model presented here, it does not matter who is required to pay the tax
(e.g., a sales tax vs. a production tax); tax incidence will be the same in each case!
Tax incidence and elasticities

• Elasticities of supply and demand are major determinants of incidence
• In general, when demand is relatively more elastic, producers will experience more
burden, and vice versa
3.4 Taxes 3
Elastic demand with inelastic supply
Consider the market for labor; workers (suppliers), are
S2 unlikely to extend or cut hours very much for a large
Wage range of wages
tax
Demand, on the other hand, may be elastic due to the
S1 presence of substitutes (outsourcing)
Wb
What happens when the government puts a tax on earned
W1 income?
tax
D • The tax shifts the labor supply curve up by the amount
Ws
of the tax; the new wage is Wb , with quantity L2
The wage received by workers, however, is only Ws
Wb –W1 < W1 – Ws ; therefore, the incidence of the tax

falls primarily on suppliers of labor (workers)
0 L2 L1 Quantity of labor
3.4 Taxes 3
Tax incidence is a term describing who actually bears the burden of a tax
• In the simple model presented here, it does not matter who is required to pay the tax
(e.g., a sales tax vs. a production tax); tax incidence will be the same in each case!
Tax incidence and elasticities

• Elasticities of supply and demand are major determinants of incidence
• In general, when demand is relatively more elastic, producers will experience more
burden, and vice versa
A general formula(s) for incidence as a function of elasticities
ES ED
Share born by consumer  S Share born by producer 
E  ED ES  ED
3.4 Taxes 3
Figure 3.16 Tax Incidence and Elasticities
Soda Tax figure it out
The supply and demand for soda in a market is represented by

QS = 50P – 60 , QD = 12 – 8P
Where P is the price per bottle, in dollars, and Q is in millions of bottles
per year
The current equilibrium price is $1.17, and 2.62 million bottles are sold per
year
1. Calculate the price elasticity of demand and the price elasticity of
supply at the current equilibrium
2. Calculate the share of a tax that will be borne by consumers and the
share borne by producers
3. If a tax of $0.10 per bottle is created, what do buyers now pay for a
bottle? What will sellers receive?
Soda Tax figure it out
1. The elasticity of demand and supply are
Q D P 1.17
E  D
 D  8   3.75
P Q 2.62
Q S
P 1.17
ES   S  50   22.33
P Q 2.62
2. The proportion of a tax borne by buyers and sellers is:
ES 22.33
Share born by buyer  S   85.6%
E E D
22.33  3.75
ED 3.75
Share born by seller    14.4%
ES  ED 22.33  3.75
3. If there is a tax of $0.10 per bottle, buyers pay 85.6%, or $0.0856 per
bottle, and sellers pay 14.4%, or $0.0144 per bottle
3.5 Subsidies 3
Subsidy – a payment by the government to a buyer or seller of a good or
service
• Subsidies are simply the opposite of a tax
Pb  subsidy  PS
Governments subsidize many products and production processes

• Producer subsidies – ethanol production, research and development
• Consumer subsidies – education, public transportation
3.5 Subsidies 3
Figure 3.17 The Impact of a Producer Subsidy
Education Grants figure it out
For years the government has subsidized higher education through grants;
consider the supply and demand for college credit hours at a local private
liberal arts college
QS = 1,000P – 2500 , QD = 8,000 – 500P
where P is the price, in hundreds of dollars, and Q is the number of credit
hours per semester
The current equilibrium price is $700, and 4,500 credit hours are taken per
semester; suppose the government subsidizes credit hours at a rate of $200
per hour
1. What will happen to the price paid by students, the price received by
the college, and the number of credit hours completed?
2. What is the cost of the subsidy to the government?
1. The first step is determining how the subsidy affects prices

Pb  subsidy  PS
In this problem,
Pb  2  PS
Supply and demand are given by
Q D  8, 000  500 Pb ; Q S  1, 000 PS  2,500

And substituting in for PS
Q S  1, 000  Pb  2   2500  1, 000 Pb  500

Equating supply and demand, and solving for Pb
8, 000  500 Pb  1, 000 Pb  500  Pb  $566.7

The new producer price is given by
Pb  200  PS  PS  $766.7
And the quantity of credit hours taken (using demand equation)
Q D  8, 000  500  5.667   5,166.5

So, the price paid by consumers has decreased by about $133, the price
received by the college has increased by about $67, and the number of credit
hours consumed has increased by about 667
2. How much did this cost the government?
Cost  subsidy  Q  $200  667  $133, 400
3.6 Conclusion 3
This chapter examined the supply and demand model in more detail, and
analyzed how government policies affect markets
In the next few chapters, we examine the microeconomic underpinnings
of demand and supply
In Chapter 4, we introduce the concept of utility, which provides context
for understanding how consumers make consumption decisions

Using Supply and Demand To Analyze Markets: Chapter Outline 3.1 Consumer and Producer Surplus

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Using Supply and

Demand to Analyze Markets 3

3.2 Price Regulations

3.3 Quantity Regulations

1. Remember: Equilibrium is characterized by QS = QD

What happens to producer surplus?

Nonbinding price ceiling – a price set at a level above the equilibrium

0 500 1,500 Quantity of

Ptot However, quantity supplied only increases to Qtot because

0 Qpriv Q1 Qtot Q1 + Qgov Quantity of rounds

0 Q2 = 3.4 Q1 = 4 Quantity of tickets

Q D  0  20  2 PDChoke  PDChoke  $10 CS  1   400,000   $10  $8  $400,000

Solving for producer surplus yields

 Why do we not substitute into the supply equation?

and quantity (substitute

How much revenue has been generated by the tax?

And the associated deadweight loss associated with this distortion is

Q D  Q S  20  2 Pb  3PS  20  20  2 PS  1.00  3PS  20

How much revenue has been generated by the tax?

And the associated deadweight

Price ($) Price ($)

Tax incidence and elasticities

Wb –W1 < W1 – Ws ; therefore, the incidence of the tax

Tax incidence and elasticities

The supply and demand for soda in a market is represented by

Governments subsidize many products and production processes

1. The first step is determining how the subsidy affects prices

Q D  8, 000  500 Pb ; Q S  1, 000 PS  2,500

Q S  1, 000  Pb  2   2500  1, 000 Pb  500

8, 000  500 Pb  1, 000 Pb  500  Pb  $566.7

The new producer price is given by

Q D  8, 000  500  5.667   5,166.5

Cost  subsidy  Q  $200  667  $133, 400

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