A Lecture Presentation in Powerpoint Exploring Economics by Robert L. Sexton

A Lecture Presentation
in PowerPoint
to accompany
Exploring Economics
Second Edition
by Robert L. Sexton
Copyright © 2002 Thomson Learning, Inc.
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Printed in the United States of America
ISBN 0030342333
Copyright © 2002 by Thomson Learning, Inc.

Chapter 6
Consumer Choice and Welfare

6.1 Consumer Behavior
 Individuals take action in response to
recognized opportunities to advance
their goals.
 This assumption that individuals act to
advance their goals—known as the rule
of rational choice—merely implies that
whatever individuals do is done with a
purpose.

 In economics we assume that each
individual seeks to maximize his or her
own well-being or satisfaction.
 Economists developed the concept of
utility to allow them to study the relative
levels of satisfaction that consumers get
from the consumption of goods and
services.

 Utility varies from individual to individual
depending on specific preferences.
 Therefore, it is not possible to compare
the relative satisfactions of different
persons.
 Total utility is the total amount of
satisfaction derived from the
consumption of a certain number of
units of a good or service.

 Marginal utility is the additional
satisfaction generated by the last unit of
a good that is consumed.
 Total utility increases with additional
consumption.
 The incremental satisfaction—the
marginal utility—that results from the
consumption of additional units tends to
decline as consumption increases.

 This law of diminishing marginal
utility means that each successive unit
of a good that is consumed generates
less additional satisfaction than did the
previous unit.

Exhibit 1: Total and Marginal
Utility
20 40
Marginal
(per pizza slice)
15 30
Marginal Utility
Total Utility
utility Total
utility
10 20
5 10
0 1 2 3 4 0 1 2 3 4
Quantity of Pizza Slices Quantity of Pizza Slices
(per hour) (per hour)

 It follows from the law of diminishing
marginal utility that as a person uses
more and more units of a good to satisfy
a given want, the intensity of the want,
and the utility derived from further
satisfying that want, diminishes.

6.2 The Consumer’s Choice
 Consumers try to add to their total
utility, so when the marginal utility
generated by the purchase of additional
units of one good drops too low, it can
become rational for the consumer to
purchase other goods rather than to
purchase more of the first good.

 A rational consumer will avoid making
purchases of any one good beyond the
point at which other goods will yield
greater satisfaction for the amount
spent.
 Marginal utility is an important concept
in understanding and predicting
consumer behavior.

 By comparing the marginal utilities
generated by units of the goods that he
or she desires as well as their prices, a
rational consumer seeks the
combination of goods that maximizes
his or her satisfaction.
 When the optimum, utility-maximizing
level of each good has been purchased,
consumers are said to have reached the
point of consumer equilibrium.
 In order to reach consumer equilibrium,
consumers must allocate their income in
such a way that the ratio of the marginal
utility to the price of the good is equal
for all goods purchased.
 When this goal is realized, one dollar’s
worth of additional gasoline will yield the
same marginal utility as one dollar’s
worth of additional bread or apples or
movie tickets or soap.
 Given a fixed budget, if the marginal
utilities per dollar spent on additional
units of two goods are not the same, the
consumer can increase total satisfaction
by buying more of a good with a higher
marginal utility per dollar and less of
another good with a lower marginal
utility per dollar.

 Consumers will continue to alter their
purchases to increase their satisfaction
until the ratio of the marginal utility to
the price of each good is equal for all
goods purchased.
 The law of demand—buying more of a
good as its price is reduced—reflects
consumer equilibrium where goods are
subject to the law of diminishing
marginal utility.
 A lower price for a good increases its
marginal utility or satisfaction per dollar,
leading to an increase in the quantity of
that good demanded.

6.3 Consumer and Producer Surplus
 What a consumer actually pays for a
good is usually less than what she is
willing to pay.
 The monetary difference between what
the consumer is willing to pay and what
the consumer actually pays is called
consumer surplus.

 Consumer surplus is shown graphically
as the area under the demand curve
(willingness to pay for the units
consumed) and above the market price
(what must be paid for those units).

Exhibit 1: Consumer Surplus
a
Price
Demand
0
Q

Quantity
 If the consumer buys several units of a
good, the earlier units will have greater
marginal value and therefore create
more consumer surplus because
marginal willingness to pay falls as
greater quantities are consumed in any
period.

Exhibit 2: Consumer Surplus for
Iced Tea
Price of Iced Tea (per glass)
$4
Consumer surplus =
$3 + $1 = $4
$3
$2
$1
Market price
$1
$ .50 DICED TEA
0 1 2 3
Quantity of Iced Tea (by glass)
 An increase in supply will lower the price
and increase your consumer surplus for
each of the units you were already
consuming.
 A supply increase will also increase
consumer surplus from increased
purchases at the lower price.
 Conversely, a decrease in supply will
increase the price and lower the amount
of consumer surplus.
Exhibit 3: The Impact of an Increase
in Supply on Consumer Surplus
Gain in consumer surplus
A from fall in price
S0
S1
B
Price
P0
C
P1
D
0
Q0 Q1
Quantity
 Producer surplus is the difference
between what a producer is paid for a
good and the seller’s cost for producing
each unit of the good.
 Because some units can be produced at
a cost that is lower than the market
price, the seller receives a surplus, or
net benefit, from producing those units.

 Producer surplus for a particular unit is
the difference between the market price
and the seller’s cost of producing that
unit.
 Total producer surplus is shown
graphically as the area under the
market price (what was paid for those
units) and above the supply curve (the
total cost, or sum of marginal costs, of
producing those units).
Exhibit 4: Producer Surplus
Supply
Price
$5 Market
$1
4 $2 Price
$3
3
2
1
0
1 2 3 4 5
Quantity
 A higher market price due to an
increase in demand will increase total
producer surplus.
 Part of the added surplus is due to a
higher price for the quantity already
being produced.
 Part is due to the expansion of output
made profitable by the higher price.

Exhibit 5: The Impact of an Increase
in Demand on Producer Surplus
S
P1 New Market
Addition to
producer surplus
Price
Price
P0 Old Market
Old
producer Price
surplus
0 Q0 Q1
Quantity
 With the tools of consumer and
producer surplus, we can better analyze
the total gains from exchange.
 The demand curve represents a
collection of maximum prices that
consumers are willing and able to pay
for additional quantities of a good or
service.

 The supply curve represents a collection
of minimum prices that suppliers require
to be willing to supply additional
quantities of that good or service.
 At the market equilibrium, consumers
receive consumer surplus and
producers receive producer surplus.
 Both benefit from trading every unit up
to the market equilibrium output.

 Buyers purchase each good, except for
the very last unit, for less than the
maximum amount that they would have
been willing to pay.
 Sellers receive more than the minimum
amount they would have been willing to
accept to supply the good.

 Once the equilibrium output is reached
at the equilibrium price, all of the
mutually beneficial trade opportunities
between the suppliers and the
demanders will have taken place.
 The sum of consumer and producer
surplus is maximized.

 The total welfare gain to the economy
from trade in a good is the sum of the
consumer and producer surplus
created.
 Consumers benefit from additional
amounts of consumer surplus and
producers benefit from additional
amounts of producer surplus.

 Improvements in welfare come from
additions to both consumer and
producer surplus.
 In competitive markets, where there are
large numbers of buyers and sellers at
the market equilibrium price and
quantity, the net gains to society are as
large as possible.

Exhibit 6: Consumer and Producer Surplus
S
$8
7
6 CS
5 CS
Price
CS
4
PS
3 PS PS
2
D
1
0 1 2 3 4

Quantity
6.4 The Welfare Effects of Taxes
and Price Controls
 We can use consumer and producer
surplus to measure the welfare effects
of various government programs, such
as taxes and price controls.

Exhibit 1: The Supply and Demand
of a Tax
Supply
PB Tax
Revenue Tax
Price
T  Q1
PS
Demand
Q1 Q0
Copyright © 2002 by Thomson Learning, Inc. Quantity
and Price Controls
 Welfare effects refer to the gains and
losses associated with government
intervention.
 After a tax is imposed, consumers pay a
higher price and lose the corresponding
amount of consumer surplus as a result.
 Producers receive a lower price after tax
and lose the corresponding amount of
producer surplus as a result.

and Price Controls
 The government gains the amount of
the tax revenue generated, which is
transferred to others in society.
 The net loss to society, or deadweight
loss, of a tax is the difference between
the lost consumer and producer surplus
and the tax revenue generated,
represented graphically as the
deadweight loss triangle.

Exhibit 2: Welfare Effects of a Tax
Deadweight S
a Loss
PB
Price
b c
TAX
P0 e
d
PS
f
D
0
Q1 Q0
and Price Controls
 The deadweight loss of a tax occurs
because the tax reduces the quantity
exchanged below the original output
level, reducing the size of the total
surplus realized from trade.
 The tax distorts market incentives.
 The price to buyers is higher than before
the tax, so they consume less, and the
price to sellers is lower than before the tax,
so they produce less.
and Price Controls
 This leads to deadweight loss, or
market inefficiencies—the waste
associated with not producing the
efficient output.
 The size of the deadweight loss from a
tax, as well as how the burdens are
shared between buyers and sellers,
depends on the elasticities of supply
and demand.

and Price Controls
 Other things equal, the less elastic the
demand curve, the smaller the
deadweight loss.
 Similarly, the less elastic the supply
curve, the smaller the deadweight loss.
 However, if either the supply or demand
curves become more elastic, the
deadweight loss will be larger because a
given tax will reduce the quantity
exchanged by a greater amount.
and Price Controls
 That is, the more elastic the curves are,
the greater the change in output and the
larger the deadweight loss.

Exhibit 3: Elasticity and Deadweight
Loss
Deadweight loss
is relatively
small. S
Price
$.50 Tax
D
0
Q1 Q0
Quantity
Loss
S
Deadweight loss
is relatively small.
Price
$.50 Tax
D
0
Q1 Q0
Quantity
Loss
Deadweight loss
S
is relatively large.
Price
$.50 Tax
0
Q1 Q0
Quantity
and Price Controls
 Elasticity differences can help us
understand tax policy.
 Those goods that are heavily taxed often
have a relatively inelastic demand curve in
the short run.
 This means that the burden falls mainly on
the buyer.
 It also means that the deadweight loss to
society is smaller than if the demand curve
was more elastic.

and Price Controls
 We can see the welfare effects of a
price ceiling by observing the change in
consumer and producer surplus from
the implementation of the price ceiling.
 Consumers can now buy at a lower
price, but cannot buy as much as before
(since suppliers will not supply as
much).

and Price Controls
 Producers lose producer surplus from
the lower imposed ceiling price.
 The net loss is the resulting deadweight
loss triangle, just as with a tax.

Exhibit 4: Welfare Effects of a Price
Ceiling
a Deadweight S
P1 Loss
b c
Price
P0 e
d Price Ceiling
PMAX f
0 Q1 Q0
Copyright © 2002 by Thomson Learning, Inc. Quantity
and Price Controls
 We can also use consumer and
producer surplus to see the welfare
effects of a price floor, where the
government buys up the surplus.
 Consumers lose consumer surplus due
to the higher price floor, and must also
pay taxes to pay for the buying and
storing of the unsold (to consumers)
output.

and Price Controls
 Producers gain producer surplus from
the higher prices and greater output
(since the government buys up what is
not sold on the market).
 On net, there is a deadweight loss from
the price floor.

Exhibit 5: Agricultural Price
Supports
P S
B C Price
$4 Floor
Price of Cheese
Surplus the
$3 government
must absorb
A D D
0
QD Q QS
Quantity of Cheese
Exhibit 6: Welfare Effects of a Price Floor
When Government Buys the Surplus
Deadweight Loss
(c + f + g + h + I) S
a
P1
Price
b c d
h
P0
f
e g i D
0
Q1 Q0 QS
Quantity

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Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

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Copyright © 2002 by Thomson Learning, Inc.

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