Maximising Consumer Surplus and Producer Surplus:
How do airlines and mobile companies do it?
This is a topic that has many powerful applications in understanding economic
policy applications:
(a)
the impact of many government interventions in the market and
eg tariff protection
eg import quotas
eg taxes
eg price control
(b)
market imperfections such as monopolies
- price discrimination
- monopoly pricing.
Absolutely critical to understand the underlying logic.
First: Long Run Industry Supply Curves,
We have seen short run equilibrium under perfect competition
What happens in the long run?
What should the Long Run Supply curve look like?
If you could predict what the “Long Run Supply Curve” looks like
for any commodity, and knowing likely demand (which is more
predictable), you could make a fortune in the “Futures” market.
In reality, despite many pre-conceptions, people have not been
able to predict what the long term supply curves are going to be
like, even for something as critical as oil (which we looked at in
our last lecture)
Suppose that demand for a product increases from D1 to D2
In the short run, price rises from Po to P 1; super-profits are made, firms are
attracted into the industry and the supply curve will therefore shift out.
The question is: where will it shift to in the long run? And what will be the new
equilibrium price? Higher? Lower? or the same?
SRS0
P ($)
P1
B
where?
Po
A
D2
D1
qo q1
L
Much depends on the markets for the inputs
If input markets not perfectly competitive eg limited land or limited labour
More firms buying inputs, pushes up the prices of these inputs for everyone, the ATC
curves rises for every firm; the SRS1 will not shift all that much, and the final
equilibrium price will be higher than Po.
AC then represents the Long Run Supply Curve for an “increasing cost” industry.
Eg with rising population, what will happen to the long term price of food?
ATC1
P ($)
SRS0
SRS1
LRS1
B
P1
Po
ATC0
A
C
D2
D1
qo
q1
But opposite may happen if there exist economies of scale
Where all the firms, with higher outputs, begin to produce with lower minimum ATCs
(or all on the declining part of their ATC curves)
Which implies that the SRS1 has shifted so far to the right that equilibrium price P1 is
less than Po. and the LRS1 represents a decreasing cost industry with a downward
sloping supply curve- i.e. the great boon of a “decreasing cost” industry.
P ($)
ATC0
SRS0
SRS1
B
ATC1
Po
A
C
P1
D2
D1
qo
q1
LRS1
Many examples in the electronics industry
Computers: Forty years ago, a basic computer used to cost $500,000 and
occupy a room 30 metres by 20 metres. There may have been perhaps 300,000
such computers in the world
Today, desk-tops far more powerful, far more user-friendly (look at the menudriven word-processing, spread-sheets, databases, modeling soft-ware). Play
CDs, DVDs, video-conferencing, electronic storage of everything,...
Also connects you to the whole world : email, Internet, persons, companies,
libraries etc etc voice, video.
Billions of computers in the world, costing less than $2000 each.
No end in sight to declining real costs and prices
Similar arguments for televisions, radios, cameras, and mobiles etc
But “in-between” “normal” case: horizontal supply curve
If the input markets are perfectly competitive, then inputs can be bought for the same
prices as originally regardless of how much of each input is purchased
Which implies that all these firms will keep producing at the bottom of the ATC curves
But there are now more firms, producing greater output
Hence the supply curve shifts to SRS1, equilibrium output is at C, and
The line AC represents the Long Run Supply Curve for a “constant cost” industry.
P ($)
SRS0
SRS1
ATC0
B
P1
Po
A
LRS1
C
D2
D1
qo
q1
Hence for normal equilibrium under Perfect Competition
We have a horizontal supply curve; usual demand curve;
With equilibrium quantity Qo; and Price = MC i.e. economic efficiency
i.e. in perfect competition equilibrium
Marginal value to society = Marginal cost to society (no externalities)
But many consumers willing to pay more than Po: demand curve above Po: AB
$
A
The value that society places
on each extra unit of output
The cost to society of producing
that extra unit of output
B
S
Po
D
O
Xo
X
Definition of Consumer Surplus
Consumer surplus exists wherever the price paid for one unit of a product by a
consumer is less than what that consumers are willing to pay for it.
If the price is Po, then the space (green lines: gap between the price line and the
demand curve) represent the consumer surplus at each extra unit of output.
Total consumer surplus is = the area PoAB.
$
A
Consumer surplus at each output level
?
B
Po
D
O
Xo
X
If price changes eg to P1 or P2 then the consumer surplus changes
If price rises to P1 then the consumer surplus declines to P 1AC.
Conversely if price declines to P2, then the consumer surplus increases to P 2AE
$
A
C
P1
B
Po
E
P2
D
O
Xo
X
Note the importance of demand elasticities
If the demand is quite elastic (D2): ie “flatter”, then a small rise in price leads to
a large reduction in demand;
ie. if fewer consumers who are willing to pay higher prices for this commodity:
the consumer surplus is correspondingly smaller: area PoBC
What would the consumer surplus be if the demand curve was completely flat?
$
A
C
B
Po
D2
D1
O
Xo
X
Interesting applications from the sellers’ point of view
If sellers can isolate all the buyers into their separate markets distinguished by
what they are willing to pay: then they could charge those with higher consumer
surplus, higher prices : And they could charge those with lower consumer
surplus, lower prices. ie practice price discrimination; but the markets must be
able to be kept separate
Three examples:
(a) Any common beverage (soft drinks or alcoholic) sold in a cafe as opposed to
an up-market resort eg Fiji stubby: $2.50 in a Chinese cafe, as opposed to $4.50
in the Holiday Inn.
(b) Airline tickets; those who plan ahead; those who have to fly urgently;
(c) mobile phone or land-line charges
Does not require monopoly for this to happen (monopoly and price
discrimination later).
How do airlines do it?
Of course, airlines could compete with other airlines simply by reducing price- all would
reduce price i.e. consumers would all be enjoying their consumer surplus. No gain to any
airline. What do airlines actually do?
Offer large discounts if you book in advance (airline gets confirmed sale, and cash in
hand - hence reduced cash-flow problem)
Closer you get to the departure date, the higher is the price for those who have to travel.
What do airlines have to do if departure date is getting closer and new bookings are not
eventuating? (especially easy given that a lot of customers are now buying online)
Sometimes just before a flight, the price drops, to fill empty seats
Is it correct that all those who book early at the lowest price available, are those whose
consumer surplus was the lowest?
Do airlines give exactly the same kinds of discounts for every destination?
How do mobile and land-line companies extract consumer surplus?
Explain why the phone companies can extract more consumer surplus by having
different basic tariff rates for:
(a) Distinguishing between pre-paid cards and post-paid cards
(b) Different rates at different times of the day
(c) Different rates for different destinations
(d) different rates for different services: what are all the different services?
(e) different groupings of customers?
(f) differentiating commercial firms from ordinary firms.
Producer surplus
Similar logic to “consumer surplus” analysis but with some subtle differences.
Simplify by passing Supply Curve through the origin
We know that at each price level the Supply curve gives the output that the firm is
willing to supply at the particular price. Anything received above that is a “gain”.
So at price Po, the area above the supply curve and below the Po line, represents the total
producer surplus enjoyed by the producer who is producing at output point Xo. (OPoB)
$
S = sum of MC curves
C
B
Po
D
O
Xo
X
Producer surplus: is not “money in the pocket” of the producers
Industry revenue = area OXoBPo.
The area under the supply curve = sum of the industry MCs = Total Variable Cost.
The industry increases output as long as MR = P > MC (which is represented by the
Supply curve: so everywhere, the “net gain” to the producer = P - MC
But of course he also has to pay his Fixed Costs
Real Net profit = OXoBPo - OBXo - Total Fixed costs
= Producer surplus OBPo - Total Fixed costs
$
S = sum of MC curves
C
B
Po
D
O
Xo
X
Producer surplus: total marginal gain of producing more
This “marginalist” reasoning about producer surplus is at the heart of marginal
analysis; once the fixed investments are made (Total Fixed Costs)
What matters for economic efficiency and the decision on the optimum amount
to produce is whether producing and selling one more unit will be such that
MR > MC
and here
MR = P > MC
i.e only whether the price line is above the Supply curve.
Fascinating application to “efficiency pricing of a good produced by a state
enterprise” in a situation where “Marginal Cost is virtually 0”: the price
should be zero.
“Total Surplus”: maximum at equilibrium price
And with “Pareto Optimality” in General Equilibrium
Total Surplus
= Consumer Surplus + Producer Surplus
= CPoB + OPoB.
Under perfect competition, this Total Surplus is the maximum available to the
economy.
$
S = sum of MC curves
C
B
Po
D
O
Xo
Q
Any other output level, will lead to a lower Total Surplus
Suppose the firm (for whatever reason, chooses to produce at lower output X1
New consumer surplus = CEP1
New producer surplus = OAEP1
Total Surplus has shrunk by EAB: called the “deadweight loss” to the economy.
$
S = sum of MC curves
C
E
P1
B
Po
F
D
A
O
X1
Xo
X
But note by how much consumer surplus has declined by
Consumer surplus has declined by PoP 1EB
But of this, one bit has been gained by the producers: PoP 1EF
Where has FEB gone to?
The net change in producer surplus = - FBA + PoP1EF
Will this be positive or negative?
Where has AFB gone to? i.e. AFEB = FEB + AFB = “?????”
$
S
C
E
P1
B
Po
F
D
A
O
X1
Xo
Q
Note that in neoclassical economics
The transfer of surplus from consumers to producers or from producers to consumers is
NOT seen as positive or negative, either way.
It is seen as merely a “transfer within society”.
Whether the producer is rich or poor, or the consumers are rich or poor.
For Neoclassical Economics,
there is no value judgment made about an extra dollar in the hands of a producer (even if
he is a monopolist, rich or poor) or in the hands of a consumer
What if for a PIC, the producers are companies (foreign or local) who invest overseas?
What if the consumers are foreigners? Can they be?
Suppose govt imposes price control: ie a price ceiling?
What will be new output? X1 or X2?
What will be the new consumer surplus? smaller or bigger than before?
What will be the new producer surplus? smaller or bigger than before?
What is the total surplus? bigger or smaller than before?
What is the “dead-weight loss”?
Has the economy gained or lost overall? Who gained? Who lost?
$
S = sum of MC curves
C
A
B
Po
E
F
P1
D
O
X1
Xo
X2
Q
What if government decrees that output must increase to X2
and must be sold at price P1?
What happens to producer surplus, producing at X2?
The increase in consumer surplus = P1PoBF
Where does this increase in consumer surplus come from?
Why is output point X2 so inefficient from society’s point of view?
What is a neat geometric expression representing this “deadweight loss”?
$
S = sum of MC curves
C
G
Po
P1
B
F
D
O
Xo X2
Q