Demand, Supply, and Surpluses

DANBY | IA&S 324 | Demand, Supply, and Surpluses

Demand, Supply, and Surpluses

Demand
The Demand curve answers this question: What quantity of a good would consumers buy at each possible price?

Suppose we have an economy of only ten consumers, and we ask them the following question: How much cake would you purchase, per day, at prices ranging from nothing to 10? Suppose are consumers are named A through J. Here are their answers.

A likes cake a lot and will pay as much as $9 for a cake. Nobody else likes cake that much. J does not like cake at all and will accept one only if it is free. Note that A happily continues to buy a cake even if it costs less than $9. (To keep our numbers simple, we assume nobody ever buys more than one cake per day.)

By adding up the quantities demanded by each consumer at each price, we can draw a "demand curve." This is just a line which shows the quantity demanded at each possible price.

Remember that we always reason from price to quantity: this shows us the quantity demanded (on the horizontal axis) for every possible price (on the vertical axis).

Here is a different way of looking at the same thing. We draw the graph as a series of columns, and the height of each column can be understood as how much each consumer likes cake, based on our simple numbers above.

Now, suppose that the largest amount a consumer is willing to pay for something is how much it is "worth" to them -- how much pleasure, happiness, value, benefit, usefulness, utility, or whatever you want to call it the consumer gets out of the good. So Consumer A gets $9 of happiness from cake, which is why she is willing to pay as much as $9 for one. Consumer B gets only $8 worth of happiness fom a cake, which is why he will not buy one for $9, but will buy one for $8. And so on.

Consumer Surplus
If that makes sense (however strange it sounds), then you have the main idea. Let us define an individual's "consumer surplus" as the difference between the most they would be willing to pay for a good, and what they actually pay. Here's how we use the concept. Suppose the price of a cake is actually $5. Consumer A buys one, paying $5 for something that provides $9 worth of happiness. So her "consumer surplus" is $4. Consumer B pays $5 for a cake that provides him $8 worth of happiness, so his consumer surplus is only $3. Consumer E pays $5 for something that provides her with exactly $5 of happiness, so her consumer surplus is zero. Consumers F-J are priced out of the market -- $5 is too high for them, so they don't buy at all.

We can show all of that on the same graph, in which the purple area represents total expenditure, and the blue area represents total consumer surplus of all the different consumers.

Supply
The Supply curve answers this question: What quantity of a good would producers make at each possible price?

Suppose we have an economy of only ten producers, and we ask them the following question: How much cake would you make, per day, at prices ranging from nothing to 10? Suppose are producers are named K through T.

K is a very efficient producer and has costs of just $1 per cake. So at a price of $1 K will produce one cake per day. None of the other producers are efficient enough to produce cake at that selling price, so at $1 nobody but K makes cake. If the price rises to $2 producer L, who could not produce profitably at $1, is just able to cover costs of $2 per cake. And so on up to producer T, who is so inefficient that its costs per cake are $9, and it will only produce when the price gets that high. Note that K continues to produce cake at higher prices. (To keep our numbers simple nobody ever makes more than one cake per day, and they will produce if they just cover costs.)

By adding up the quantities supplied by each producer at each price, we can draw a "supply curve." This is just a line which shows the quantity supplied at each possible price.

Remember that we are still reasoning from price to quantity: this shows us how much our producers will make in response to each possible price.

Here is a different way of looking at the same thing. We draw the graph as a series of columns, and the height of each column can be understood as the cost per cake for each producer.

Producer Surplus
If that makes sense, then we're almost done. Let us define a firm's "producer surplus" as the difference between its cost and what it actually gets for the good. You can think of this, in very simple terms, as the firm's profit (assuming zero fixed costs, but don't worry about that -- this is not a microeconomics class). Here's how we use the concept. Suppose the price of a cake is actually $5. Producer K makes one, receiving $5 for something that costs it $1. Its "producer surplus" is $4. Producer L receives $5 for a cake that cost it $2 tp make, so its producer surplus is only $3. Producer O receives $5 for something that cost it $5 to make, so its producer surplus is zero. Producers P-T would lose money if they made and sold cake at a price of $5, so they make no cake. We can show all of that on the same graph, in which the red area representing costs, and the yellow area representing total producer surplus of all the different producers.

Putting it together
Note that the yellow area plus the red area represent total consumer spending, and are the same as the purple area in the consumer graph.

We can show both consumer and producer surplus at the same time:

Note that in this presentation, with only a few producers and consumers, the areas have a step-like shape. As we move to markets involving larger numbers of people they will become smoother triangles, as in the web material on tariffs and quotas.

Finally, here are the same demand and supply graphs in their more traditional configuration.

Assumptions and Applicability

Consider these statements:

1. When the price of a good rises then, normally, people will buy less of it. And when the price of a good falls then, normally, people will buy more of it.

2. When the price of a good rises then, normally, producers will make more of it. And when the price of a good falls then, normally, producers will make less of it.

3. When the price of a good rises, some people who were buying it before will keep on buying it, and they are now worse off than before. And when the price of a good falls people who were buying it before will keep on buying it, and they are now better off than before.

4. When the price of a good rises, producers who were making it before will keep on making it, and they are now better off than before. And when the price of a good falls some producers who were making it before will keep on making it, and they are now worse off than before.

Think for a few minutes about how these four statements relate to each other. Statements (1) and (2) are describing production and purchases that are changed by a price movement. Statements (3) and (4) add insights about the buying and selling and producing that continues happening despite a price movement.

Statements 1-4 are, I claim, reasonably plausible assertions about the real world. And if we are going to talk about the effects of a price change on people, we need (3) and (4) and not just (1) and (2). We need a way to talk about all the effects of a price change on all market participants.

The reason we’re learning the concepts of consumer and producer surplus is so that in unit 2 of this course we can think through the effects of trade restrictions. And I can tell you where this is going: if we apply a trade restriction in order to benefit a domestic producer of a good (for example tariffs on clothing imported into the United States) that tariff has the effect of raising the price of clothing in the United States, and thus helping U.S. producers, who can sell at a higher price – you’re basically raising the price of the foreign good by taxing it as it crosses the border, and thus reducing price competition faced by the domestic producer. What that means is that the benefits gained by domestic producers are coming out of the pocket of domestic U.S. consumers. So having the concept of consumer and producer surplus will enable us to talk about these costs and benefits in a more rigorous, thoughtful way.

Now I’ve just said that statements 1-4 are reasonable statements about the world. But many economists don’t like to just write like that. They prefer to make little mathematical models that start with a small number of assumptions and generate statements like 1-4 as logical results. A mathematical model is just that: a model of reality, not reality itself, and the benefits of clarity and simplicity always come with some costs of unrealism. The standard market model that we are developing above relies on some standard assumptions to get what’s called perfect competition. Roughly it assumes:

· The product is standardized and everyone has perfect information about it (no brands, no worries about quality).

· There are many buyers and sellers, and everyone acts like they have zero pricing power – they are price-takers not price-makers. Firms can sell as much as they want at the market price.

· There is easy entry and exit from the market, so that new firms can always come in if they spot profit-making opportunities.

There are serious realism problems with these assumptions, especially on the supply side of the market. Why do we use these assumptions then? Because it makes the math easy. It’s easy to model a market of many tiny price-taking producers. It’s also easy to model a market where there is a single monopolist. But in between, where most production happens, it’s much harder to predict what firms will do. To some degree, that’s why people study business! If all production were under conditions or perfect competition or perfect monopoly, managing firms would be dead easy.

There’s a little more discussion of assumptions in my next page on this model, on price determination.

So I’m asking you in this course to keep two levels of reality in view: the messy reality of the world, and the much neater, but oversimplified, reality of models of the world. The reason I ask you on exams to write out adjustment stories is that I want to be sure you are aware of the differences between reality and models. This is important because people often make policy arguments right out of models – the model shows X is the best policy, so we should do X. That’s bad reasoning. On the other hand, using a model does help us avoid what I call “magic beans” reasoning, by which I mean over-hopeful claims that a given policy will produce nothin’ but winners. Politicians and the media often default to a vague, metaphorical language in which everything goes up and gets better and so on, and that’s not usually true.

We can talk as we go forward about the differences between reality and model. Let me just flag two here:

a. The standard market model has almost nothing to say about entrepreneurship, innovation, and rapid, dynamic change. It’s what’s called a “static” model, locating small differences by holding everything else constant.

b. The standard market model downplays adjustment problems. The assumption of easy entry and exit from markets suggests a world in which labor and capital can easily shift from one industry to another.