Microeconomics Study Notes: Surplus, Efficiency, Elasticity, and Consumer Choice

Economic Surplus and Market Efficiency

Consumer Surplus

Consumer surplus is the difference between the highest price a consumer is willing to pay for a good or service and the price they actually pay. It represents the economic value gained because consumers pay less than their maximum willingness to pay.

• Definition: The area above the market price and below the demand curve.

• Formula: $\text{Consumer Surplus} = \frac{1}{2} \times Q_d \times \Delta P$

• Example: If the quantity demanded is 1,000 and the price drops from $36 to $58, consumer surplus is $0.5 \times 1,000 \times (36-58) = -$11,000$ (Note: This example seems to have a negative value due to the order of subtraction; typically, use $\text{higher price} - \text{lower price}$).

• Application: Consumer surplus increases as the price of a good falls and decreases as the price rises.

Producer Surplus

Producer surplus is the difference between the lowest price a firm is willing to accept for a good or service and the price it actually receives. It measures the benefit producers receive from selling at a market price higher than their minimum acceptable price.

• Definition: The area below the market price and above the supply curve.

• Formula: $\text{Producer Surplus} = \frac{1}{2} \times Q_s \times \Delta P$

• Example: If the quantity supplied is 50 and the price increases from $16 to $58, producer surplus is $0.5 \times 50 \times (58-16) = $1,050$.

Economic Surplus

Economic surplus is the sum of consumer surplus and producer surplus. It represents the total net benefit to society from the production and consumption of goods and services.

• Formula: $\text{Economic Surplus} = \text{Consumer Surplus} + \text{Producer Surplus}$

• Application: Used to evaluate market efficiency and the impact of policies.

Economic Efficiency

Economic efficiency occurs when the marginal benefit to consumers of the last unit produced equals its marginal cost of production. This is the point of maximum total surplus and peak efficiency.

• Why it matters: Ensures resources are not wasted and maximizes the welfare of both producers and consumers.

• Application: Used to assess the effectiveness of market outcomes and policy interventions.

Deadweight Loss

Deadweight loss is the reduction in economic surplus resulting from a market not being at competitive equilibrium, often due to price controls, monopolies, or taxes.

• Causes: Monopolies, price floors/ceilings, tariffs, and taxes.

• Example: Tariffs increase the price to import goods, reducing consumer surplus and creating deadweight loss.

Government Price Controls

Price Floor

A price floor is the minimum price that must be paid for a good or service. It cannot fall below a set level, often used in markets like agriculture.

• Effect: Can create surplus if set above equilibrium price.

Price Ceiling

A price ceiling is the maximum price that can be charged for a product or service. It is typically set to protect consumers from high prices.

• Effect: Can create shortages if set below equilibrium price.

• Government Role: Adjusts price controls as needed to balance market outcomes.

Elasticity: Responsiveness of Demand and Supply

Price Elasticity of Demand (PED)

Elasticity measures how much one economic variable responds to changes in another. Price elasticity of demand (PED) shows how sensitive the quantity demanded of a good is to changes in its price.

• Formula: $\text{PED} = \frac{\% \text{ change in quantity demanded}}{\% \text{ change in price}}$

• Types:

  • Elastic Demand: PED > 1 (quantity demanded changes more than price)

  • Inelastic Demand: PED < 1 (quantity demanded changes less than price)

  • Unit Elastic: PED = 1 (quantity demanded changes exactly as price)

  • Perfectly Inelastic: PED = 0 (quantity demanded does not change with price)

  • Perfectly Elastic: PED = ∞ (any price change causes quantity demanded to drop to zero)

• Determinants:

  • Availability of substitutes

  • Income share spent on the good

  • Time horizon

  • Luxury vs. necessity

  • Definition of the market

• Application: Helps predict consumer behavior and set pricing strategies.

Price Elasticity of Supply (PES)

Price elasticity of supply (PES) measures how sensitive the quantity supplied of a good is to changes in its price.

• Formula: $\text{PES} = \frac{\% \text{ change in quantity supplied}}{\% \text{ change in price}}$

• Types:

  • Elastic Supply: PES > 1

  • Inelastic Supply: PES < 1

  • Unit Elastic Supply: PES = 1

• Determinants:

  • Time to adjust production

  • Number of firms

  • Mobility and efficiency of factors of production

  • Capacity

Total Revenue and Elasticity

Total revenue is the amount of funds a firm receives from selling a good or service. The relationship between price elasticity and total revenue is crucial for pricing decisions.

• Formula: $\text{Total Revenue} = \text{Price} \times \text{Quantity}$

• Elastic Demand: Price increase leads to total revenue decrease.

• Inelastic Demand: Price increase leads to total revenue increase.

• Unit Elastic: Total revenue remains unchanged.

Consumer Choice and Utility

Consumer Utility

Utility is the enjoyment or satisfaction people receive from consuming goods and services. Consumers aim to maximize their utility within their budget constraints.

• Marginal Utility: The change in satisfaction from consuming one additional unit of a good or service.

• Total Utility: The total satisfaction received from consuming a certain quantity of goods or services.

• Law of Diminishing Marginal Utility: As consumption increases, the additional satisfaction from each extra unit decreases.

• Budget Constraint: Consumers must allocate limited resources among competing goods and services.

• Formula: $\text{MU per Dollar} = \frac{\text{Marginal Utility}}{\text{Price}}$

Effects of Price Changes

• Income Effect: When the price of a good falls, consumers have more purchasing power, increasing quantity demanded.

• Substitution Effect: When the price of a good falls, it becomes relatively cheaper compared to other goods, leading consumers to substitute towards it.

• Nonmonetary Effects: Includes time, effort, inconvenience, and emotional distress.

• Monetary Effects: Out-of-pocket financial expenditure required to produce or consume a good or service.

Behavioral Economics

Behavioral economics studies how psychological factors affect economic decision-making, including sunk cost fallacy, loss aversion, and commitment bias.

• Sunk Cost Fallacy: Tendency to continue investing in a decision due to previously invested resources.

• Loss Aversion: Preference to avoid losses rather than acquire equivalent gains.

• Commitment Bias: Psychological commitment to a decision, even when it is no longer optimal.

Summary Table: Types of Elasticity

Type	Definition	Value	Example
Elastic Demand	Quantity demanded changes more than price	PED > 1	Luxury goods
Inelastic Demand	Quantity demanded changes less than price	PED < 1	Necessities
Unit Elastic	Quantity demanded changes exactly as price	PED = 1	Proportional change
Perfectly Inelastic	No change in quantity demanded	PED = 0	Life-saving drugs
Perfectly Elastic	Any price change causes quantity demanded to drop to zero	PED = ∞	Identical goods in perfect competition

Key Economic Ideas

• People are rational

• People respond to incentives (such as price changes)

• People make decisions at the margin

Additional info:

• Some examples and explanations have been expanded for clarity and completeness.

• Formulas and definitions have been standardized for academic accuracy.