Lecture-3: Market Equilibrium and Applications

Abdul Quadir
XLRI

September 1, 2020
Readings

Chapter 5 of the Textbook

Consumer Surplus

I Consumer’s Surplus: The difference between the maximum

amount that a consumer is willing to pay and what he or she
is actually paying
I For instance, suppose you are willing to pay 1 lac rupees for a
Macbook Air, but the price of Macbook Air is 90k
I Then 10k is your consumer surplus.
I CS=Maximum willingness to pay − Actual Payment
I Suppose a consumer wish to consumer more than 1 unit, then
how can we compute CS?
I We can we derive it from looking at the demand function
I In other words, we can trace the consumer’ willingness to pay
through demand curve.
Graph: CS

price per litre CS=25+15+5=45

50

40

30
25 Price
20

10

q (litres)
1 2 3 4 5
Graph: Consumer’s Surplus
I The CS is the area under the demand curve and above the
price
I For a smooth demand curve, it is depicted below:

price per litre

CS=Area of Black Triangle

p∗

q (litres)
q∗
Example: Consumer Surplus

Suppose the firm sells 20 rupees per litre

price per litre How many litres a consumer will consume?
What is firm’s revenue?
50 What is consumer’s surplus?
What is total value of 3 litres to a consumer?
40

30

20

10

q (litres)
1 2 3 4 5
Example: CS

Suppose the equation Q = 400 − 4P represents a consumer’s

monthly demand curve for milk, where Q is the number of litres of
milk purchased when the price is P rupees per litre.
1. What is the consumer surplus per month if the price of milk is
Rs. 30 per litre?
2. What is the increase in consumer surplus if the price falls to
Rs. 20 per litre?
Example: CS

CS=9800
P CS=12800
∆CS = 3000
100

30
20

Q
280 320 400
Producer Surplus

I Unlike consumers, producers would like the prices as high as

they could be
I Producer Surplus: It is the amount of money producers
receive in excess of the amount necessary to induce them to
produce the good
I Geometrically, producer surplus is the area above the supply
curve but below the market price of the good
I Social Surplus: It is the sum of consumer surplus and
producer surplus
I Deadweight loss The net loss of producer and consumer
surplus
I When supply and demand interact freely, competitive markets
produce what people want at least cost, that is, they are
efficient
Example: Producer Surplus

px = 400 1
3 + 3q
p PS = Area of triangle ABC
PS=106, 668

S
B
400 A

400
3 C
q
800
Market Efficiency

competitive markets maximize the sum of CS and PS

p

p∗

q
q∗
Dead-weight Loss: Underproduction

sum green and red triangle is the deadweight loss

p

pu

p∗

q
qu q∗
Exercise

I When demand is estimated to be p = 50 − 0.5x, calculate the

loss in consumer surplus when a tax drives price from 1 to 5.
I Let the demand and supply functions for a product is given

20
p = p(q d ) = and p = p(q s ) = q + 2
q+1
. Find the equilibrium price and quantity. Then compute the
consumer and producer surplus.
Applications of Demand and Supply
Price Rationing

I Market system is also known as price system provides an

automatic mechanism for distributing scarce goods and
services
I In other words, it serves as price rationing device
I Price rationing: The process by which the market system
allocates goods and services to consumers when quantity
demanded exceeds quantity supplied
Example: Price Rationing

p
S1

S0
2200

2000

q (metric ton)
600 720 800
Demand-determined Price
I Is there always a price that will clear the market?
I What about you owns a piece of land and you do not want to
sell it
I The price of very scarce resources are very high if there are
many demanders of that such as painting, antiques etc
I In this situations, we say that price is demand-determined
p

D
painting
1
Rationing of Demands

I Sometimes both governments as well as private organizations

would like to ration some items if there is excess demand of it
I They use mechanisms for rationing other than market
mechanism
I What is the rationale for rationing then?
I The most cited rationale is “fairness”
I For instance, rent controls, insurance premiums etc.
I Regardless of the rationale, two things are clear:
1. Attempts to bypass price rationing in the market and to use
alternative rationing devices are much more difficult and costly
than they would seem at first glance.
2. Very often, such attempts distribute costs and benefits among
households in unintended ways
Rationing of Demands

I Sometimes both governments as well as private organizations

would like to ration some items if there is excess demand of it
I They use mechanisms for rationing other than market
mechanism
I What is the rationale for rationing then?
I The most cited rationale is “fairness”
I For instance, rent controls, insurance premiums etc.
I Regardless of the rationale, two things are clear:
1. Attempts to bypass price rationing in the market and to use
alternative rationing devices are much more difficult and costly
than they would seem at first glance.
2. Very often, such attempts distribute costs and benefits among
households in unintended ways
Application 1: Price Ceilings

I Suppose there is an excess demands of a product even at a

very low price, say zero
I Then how you are going to allocate the product among those
who wants it
I There is no mechanism that will distribute it in a way that
everyone will be happy
I The price system does this job very elegantly through
prices
I Does it do it fairly?
I No. But unfairness is not the result of market system, it
is the result of scarcity
Example: Price Ceilings

p∗
A B
pc

q
qc q∗ qd
Price Ceilings

I There is excess demand q d − q c at price p c

I There could be two reasons for this shortage:
1. Fewer producers are willing to sell at this price
2. More consumers are willing to consumer this product because
it has become cheaper
I Since it is not rationed through market system, then how is it
prudent to serve some consumers only?
I It could be ‘first come, first served’ basis
I This could result in a long queue
I There will be opportunity costs of waiting in the queue
Price Ceilings

I There is excess demand q d − q c at price p c

I There could be two reasons for this shortage:
1. Fewer producers are willing to sell at this price
2. More consumers are willing to consumer this product because
it has become cheaper
I Since it is not rationed through market system, then how is it
prudent to serve some consumers only?
I It could be ‘first come, first served’ basis
I This could result in a long queue
I There will be opportunity costs of waiting in the queue
Price Ceilings
p full = pc + (p full − p c )
full price rupee price nonpecuniary price
Net loss in PS = green triangle
p
Net loss in CS = red triangle

p full

p∗
B
pc
A
D

q
qc q∗ qd
Example: Price Ceiling

I Suppose the supply and demand function for a product are

given by
q d = 100 − 2p q s = 20 + 2p
I What is the market equilibrium price and quantity?
I p ∗ = 20 and q ∗ = 60
I Suppose government puts a price ceilings of 15 rupees. How
much will be supplied and what is loss to the society?
I p c = 15, q c = 50, q d = 70, q d − q c = 70 − 50 = 20,
p full = 25
Example: Price Ceiling

I Suppose the supply and demand function for a product are

given by
q d = 100 − 2p q s = 20 + 2p
I What is the market equilibrium price and quantity?
I p ∗ = 20 and q ∗ = 60
I Suppose government puts a price ceilings of 15 rupees. How
much will be supplied and what is loss to the society?
I p c = 15, q c = 50, q d = 70, q d − q c = 70 − 50 = 20,
p full = 25
Example: Price Ceiling

I Suppose the supply and demand function for a product are

given by
q d = 100 − 2p q s = 20 + 2p
I What is the market equilibrium price and quantity?
I p ∗ = 20 and q ∗ = 60
I Suppose government puts a price ceilings of 15 rupees. How
much will be supplied and what is loss to the society?
I p c = 15, q c = 50, q d = 70, q d − q c = 70 − 50 = 20,
p full = 25
Example: Price Ceilings

p full = 25

20

p c = 15

q
50 60 70
Comments on Price Ceilings

I Note that price ceilings are not economically beneficial. Then

why price ceilings?
I The answer lies who gets benefits and who gets harmed by
ceilings
I People have different opportunity costs of standing in a queue
I In case of shortage arising because of ceilings, there are other
ways of distributing the objects
I most favored customers
I Coupons
Application 2: Price Floor

I Note that price ceilings is imposed often because price

rationing is viewed as unfair
I Note that price ceilings are inefficient and could be equally
unfair
I Sometimes a price floor is imposed
I Price floor: A minimum price below which exchange is not
permitted
I If a price floor is set above the equilibrium price, the result will
be excess supply.
I Quantity supplied will be greater than quantity demanded
I Minimum wage and minimum support price (MSP) are the
common examples of price floor
Price Floor

S
A B
pf

p∗

q
qd q∗ qf
Price Floor

I There will be surplus because of price floor

I In case of agricultural produce, government buys out the
surplus
I The total expenditure to the government is p f (q f − q d )
I Example: Suppose the supply and demand are given as

q d = 100 − 2p q s = 20 + 2p

I Price floor is fixed at p f = 40

I q f = 20 + 2 × 40 = 100, q d = 100 − 2 × 40 = 20, surplus=80
I Cost to the government is 40 × 80 = 3200
Application: Taxes

I Taxes lead to two prices:

1. prices that consumers pay
2. prices that producers receive
I There are various forms of taxes. Two prominent ones are:
1. quantity taxes: per unit tax
2. value taxes (also called ad valorem taxes): It is a tax
expressed in percentage units
I Let pd and ps be the demand and supply prices
I For quantity tax: pd = ps + t and for value tax:
pd = (1 + τ )ps
Quantity Tax

I To solve a problem with quantity tax, we consider the

following two equation:

q d (Pd ) = q s (Ps ) (1)

ps = pd − t (2)

I Substitute 2 into 1, we get q d (pd ) = q s (pd − t) or

q d (ps + t) = q s (ps )
I Alternatively, we can use inverse demand and supply pd (q)
and ps (q) to analyze quantity tax
I qd (q) − t = ps (q)
Example: Tax

I Suppose the demand and supply are give by

q d (p) = a − bp
q s (p) = c + dp

I Suppose the government imposes per unit tax of t

I What is the new equilibrium?
I qd (pd ) = qs (ps ) and pd = ps + t, thus ab pd = c + dps
I This implies

a − c − bt
a − b(ps + t) = c + dps ⇒ ps∗ =
b+d
a − c + dt
pd∗ =
b+d
Example: Tax

I Suppose the demand and supply are give by

q d (p) = a − bp
q s (p) = c + dp

I Suppose the government imposes per unit tax of t

I What is the new equilibrium?
I qd (pd ) = qs (ps ) and pd = ps + t, thus ab pd = c + dps
I This implies

a − c − bt
a − b(ps + t) = c + dps ⇒ ps∗ =
b+d
a − c + dt
pd∗ =
b+d
Deadweight Loss of Tax
p

Amount of Tax

Net loss in PS
S
pd

Net loss in PS
ps

pd (q)
q
q∗