Economic Surplus and Efficiency - Video Tutorials & Practice Problems

Economic Surplus

now let's see what happens when we put producer surplus and consumer surplus together on the same graph. So we're gonna have this idea of economic surplus and economic surplus is the sum of the consumer surplus and the producer surplus. All right, so it's gonna be our total surplus here. Economic surplus. We're gonna call it our total surplus as well, right? Total surplus. So when are we going to maximize surplus? Right. We talk about maximizing a lot, maximizing profit, maximize revenue. We want to maximize surplus as well here, and that's gonna be when the market is in equilibrium. Okay, So when we have that equilibrium, that is when we are going to have maximum surplus. So let's look at that on the graph. Look at this uh kind of standard um supply and demand graph here, right, we've got our price, access our quantity, access our downward demand, double Ds upward supply. Right? So what's going on here? We've got our maximum surplus in this case, and I'm gonna show you why in a second. But just to be clear, we have this price of P star, right, We are at equilibrium, we've got P star Q star our equilibrium price and equilibrium quantity. And what do we have at that price? Our consumer surplus is going to be this purple area that I'm highlighting now, right, everything below the demand curve, but above uh price, right? That's our consumer surplus, which I'll write out here, and now let's do the same thing with producer surplus, that's gonna be everything below the price. But above the supply curve, right? And that's gonna give us this area in green, Right? So when we add the green area the producer surplus with the consumer surplus, that is where we get our total surplus or economic surplus. Right? So this is the case where it's maximized, right? We're gonna have the most area between the supply and demand curve when we're at equilibrium. So let's go ahead and see a situation where we're not at equilibrium, right? So we're going we have what's called a deadweight loss when we're not at equilibrium. So if we're not an equilibrium it's called a deadweight loss that that emerges here and that comes from the inefficiency of not being at equilibrium. Right? So let's go ahead and look on this graph um we're gonna see we've got these different prices, right? We had our equilibrium price here, P Star and Q. Star, right? But now let's go ahead and say that the price is set too low, right? And you as a consumer you're like yeah low price. I love it. This is great for us. Um which is true, you're gonna see that consumers do benefit from that still but let's see what happens um in this situation. So quantity low here, I'm gonna put as well so I'm gonna go ahead and label these boxes these different areas of the graph, I'm gonna call this area A. B. C. D. What do you think about this last one? I'm E. Sounds pretty good. Alright. So we've got those five different areas of the graph kind of cut off by those dotted lines, right? So let's talk about consumer surplus and producer surplus in each of these situations, and then we'll talk about dead weight loss. So first at equilibrium, we've got our consumer surplus, which is everything above the price, right? So our equilibrium price was right here, right? The P. Star, So we're gonna have this area. Um And I wouldn't I suggest you don't go ahead shading everything, cause I'm gonna be uncovering stuff and we're gonna be making different areas out of this graph. So just kind of follow along here and see where I'm going. Um So that area is gonna be our consumer surplus, right? A plus B. You're gonna see is our consumer surplus. So I'm gonna write it in here, A plus B. Is the area that makes consumer surplus there. And let's go ahead and do the same thing with producer surplus. So producer surpluses everything below the price, above the supply curve, right? And that's gonna give us this triangle, the one we're used to, right? So remember an equally equilibrium, we've got our maximum uh surplus, our maximum economic surplus, which is everything is gonna be surplus. So here C. Plus D. Plus E. R. All producer surplus in this case. All right. So I'm gonna go ahead and um erase these colors and let's do the same thing at the low price. So now let's talk about consumer surplus and producer surplus at P. L. Right now we're at that low price. So what are we gonna see that's happening? Um Let's talk about consumer surplus first. Right? You're like, hey, low price. I love it. Let's go ahead and see what happened to producer surplus. Or excuse me, consumer surplus. So in this case, it's gonna be everything above the price of P. L. Right? So you might think at first that it's gonna be this whole area here, including B. And D. Right? That might be your first guess at what our consumer surplus is going to be. But that's not right. Because if you think about area B. And D. Those trades are not happening at the low price, right? If we're at this low price, let's think about this real quick at this low price. Right here, the quantity exchange is this quantity low. So those exchanges pass to the right that are happening in the area of B. And D. Those didn't happen, right? And if the trade didn't happen, no surplus happened, right? Because it has to, the exchange has to happen for the surplus to exist. Alright. So that is actually not gonna be the area of our consumer surplus, because B and D. Are not part of our surplus, right? Those exchanges didn't happen, there's no surplus there. So what we're gonna see is that our our surplus, our consumer surplus is going to be this area right here, A. And C. Okay, so that area of B. And D. Those trades didn't happen, and you can kind of guess what's gonna happen with B and D in a second. All right, So A. Plus C. Is now our consumer surplus. Let's talk about producer surplus, right? And as we expected, producer surplus at a lower price, right? When the price goes down, producers would rather have high prices, right? They want to sell it for as high as possible, The price went down there, they're gonna lose surplus in this situation. So at this low price, it's everything below um the price which is pl but above the supply curve, and notice what's the only thing in there is just e, right, is the only area uh for the producer surplus. So producer surplus has decreased, just like we expected, right, the price went down, producer surplus decreased, right? And um it looks like consumer surplus increased, Right? That area seems bigger than the A plus B area, the A plus C. So we did gain something as consumers, but at what cost to society, Right? So remember in equilibrium, we didn't have deadweight loss, right? There's no deadweight loss in equilibrium, um because we're maximizing efficiency, but in this case when we have a low price, we're not at our efficient price, right? Our equilibrium price, we're going to have deadweight loss right here, the deadweight loss is gonna be B. And deep, and this is because those exchanges didn't happen if the market had set the correct price or if there was um yeah, if we were at equilibrium, we would have got that as surplus. But since we didn't exchange up to the equilibrium quantity, we stopped earlier because of this different price. Um these exchanges didn't happen and society is worse off for it, Right. People that would have exchanged didn't end up exchanging. So our dead weight loss is B plus D. That's the part of our surplus that are no longer existing at the low price. All right. So let me just do a quick uh guide right here, just so you have it for later. So blue green or purple green and blue purple is gonna be the consumer surplus producer surplus here, and dead weight loss is blue. Alright, so before we end here, let's talk about efficiency real quick. Let's go back to that topic of efficiency. So why is it efficient at equilibrium? We've talked about it before right. With productive efficiency and allocated efficiency. But let's go back to this idea of marginal benefit, right? The marginal benefit equals the marginal cost to the producer. And when we're talking about consumer and producer surplus. Originally, remember I told you that the demand curve represents willingness to pay, which represents our marginal benefit and the supply curve represents the willingness to sell, which represents the marginal cost. And remember that key formula, marginal benefit equals marginal cost. Even if you don't want to dive into it too much marginal benefit equals marginal cost. That's gonna be the key formula here. And we always want to be producing at that point, whether you want to understand it or not, marginal benefit equals marginal cost and that's what we're at right here. Right? So we reach productive efficiency because at this equilibrium price, it forces the suppliers to to work to bring down their cost as much as possible to stay competitive. The competition forces them to be as efficient as possible, or else someone more efficient will come in and steal your business, right? Because they can offer it at a lower price. Um And we're also gonna reach allocated efficiency. Right? Remember allocated efficiency has to do with consumer preferences. Right? So in this specific market, um the consumers want so much of this good. Right? And we reach allocated efficiency because we're producing the correct amount of this good at that price, Right? So allocated efficiency, it has to do with those preferences, right? And at is where we're satisfying the right amount of preferences. If we were to satisfy anymore. If we were to go past equilibrium, we would be wasting resources where they could be better spent somewhere else. And if we don't reach equilibrium, we're not allowing trades to occur that should be occurring that are beneficial to society. And that's what we saw here, right? We didn't reach equilibrium. We had a price too low, the quantity too low, and we had a dead weight loss. But you're gonna see on the next page that overproduction and over trading is also a problem, too. So let's go ahead to the next video and talk about that a little more.

Deadweight Loss and Market Failure

So like I said, dead weight loss happens in cases of under production and in cases of overproduction. Alright. And I'm gonna introduce you to what I call the bowtie of dead weight loss. All right, This is my thing. D. W. L. Is sometimes the acronym we use for dead weight loss. I'll probably use it just to to shorten the writing. But let's talk about this bow tie of deadweight loss. We're gonna see it in a second. Um Let's start in this case of under production. Right? So in the case of under production, which is kind of what we saw in our example before we have a price that's too low, right? We have a price under equilibrium price, right? Equilibrium being right here, P. Star um And at this price that's too low, we're gonna have a shortage, right? Because at the low price a lot of people are gonna want the product but the suppliers aren't going to want to supply. So we're gonna end up at this quantity right here, right at this quantity and notice the we have this shortage, right? The people demand that much out here but the supply is is that inner number, right? This is gonna be the quantity supplied and this is gonna be the quantity exchange to write because the supply um is small. The one that's smaller is the one that's going to be exchanged. So let's go ahead and see what happens here um in this case just like we saw before we had this dead weight loss here. Right? These are the trades that didn't happen. That should have happened if the price was correct. Right? So, I'm gonna highlight it in blue deadweight loss right here. Right? And now, let's see the same thing in the in the situation where uh prices too high, Right? So, now we're gonna have a situation where the price is above equilibrium, right? This was our equilibrium here, price equilibrium. Right? And now, what's gonna happen at this price? Um we are not going to we're gonna exchange the same amount, right? Because only this much is demanded. This is the quantity demanded right here, but the quantity supplied is way out here, right way out there. So they're producing way more than the demand at this level, So there's gonna be a surplus, there's excess supply, they're producing more than is necessary. Right? So, what, where is our dead weight loss in this situation? Well, in this situation, um are dead weight loss ends up being on this side of the graph. Okay, because we overproduced, right, the overproduction, uh cause there to be wasted resources into this product that could have been better spent somewhere else. Right? We produced past the equilibrium quantity, we should have just produced up to the equilibrium quantity. So our dead weight loss is going to be this blue area that I'm highlighting now. Right? So I just want to point out, and this is why I call it the bow tie of deadweight loss, right? Because the deadweight loss always happens within these areas. I've seen a lot of students mess up and call this the deadweight loss up here? Or this the deadweight loss down here, Right? And that that's completely wrong. You're gonna fail if you do, right? So the easiest way I like to think about it is dead weight loss is always gonna be in this bow tie, it's either gonna be on the left or the right. So here's our boat, I'll do it in green, Right? This is the deadweight loss bowtie here in green, and it's gonna be one of those two triangles, right? Here's our dude wearing his bow tie, right? You see it? Um So the idea here is, I'll just leave it in there. Uh that when we under produce, we're gonna have the left side of the bow tie br deadweight loss. And when we overproduce, we're gonna have the right side of the bow tie, br deadweight loss. Cool, Alright, so that is what it is what we see the deadweight loss actually from overproduction as well. So, under production, uh is not the only problem. Overproduction can happen as well. So, last thing, before we wrap this up is what we call a market failure. When the market fails to be efficient, it's a market failure, right? It's not what it it's not doing, what it's supposed to do, right? We're failing, and there's reasons for the market failure, right? What could cause a market failure first. There could be price or quantity regulations, right? The government can come in and say, hey, the price of this product has to be this amount, right. They could have some reason that they're trying to, to set a price. It happens all the time, um, or quantity regulations, right. The government could say, hey, only this much can be produced of this product. Um, either way that can cause a market failure, because we're not at equilibrium, it's causing us not to be an equilibrium. Next. We have this idea of externalities. We're gonna dive into this topic way more in a different chapter, but externalities is basically, um, cost to people outside transaction costs or benefits, really, costs or benefits to people outside the transaction. And the most common example of this transaction, let's get that word out there. The most common example is pollution, right? So even though you're, you buy this product and it gets supplied maybe that, that factory that's creating that product is polluting the environment, right? And that pollution is affecting people outside the trade. It's affecting the neighbors of the factory. It's affecting the world in general. So there's these costs that aren't being included, um, and those are called externalities, and we're gonna dive into it way more. But these are ways that the market can fail. A monopoly. So monopoly is when there's only one seller of a product. And you can imagine when there's one seller, they're gonna have influence over the price, they're the only ones selling this. Um, So they're going to influence what the market prices and we're not going to be an equilibrium in that case, they're gonna try and make as much money as they can, and we're gonna talk about monopolies a lot more to in a later chapter. So, last one here, high transaction costs. And you can imagine that high transaction costs could cause trades to not happen. Imagine if Ebay increase their trade, their their fee to like $100 per trade, right? A lot of trades that are happening on Ebay, we wouldn't happen anymore because of these high transaction costs and that would be a failure to the market, right? These trades that should be happening are being stopped because of the transaction costs. Alright, So market failure, that's when we're inefficient. We have a market failure. All right. So let's go ahead and move on to the next video