Pricing

1. Policy & the Perfectly Competitive Model:
Consumer & Producer Surplus

2. Recall:
Consumer surplus is the difference between what the consumer
has to pay for a good and the amount he/she is willing to pay.
S
D
P
Q
P*
Q*
It is the area under the demand curve & above the price.

3. Producer surplus is the difference between what the
producer receives for the good and the amount he/she must
receive to be willing to provide the good.
S
D
P
Q
P*
Q*
It is the area above the supply curve & below the price.

4. Social Welfare
Social welfare = consumer surplus + producer surplus.
In cases where there is tax revenue involved, that is
added as well in the computation of social welfare.

5. Let’s look at the sizes of the consumer &
producer surpluses at various output levels.

6. At quantity Q1 & price P1, consumer surplus is the
purple area & producer surplus is the green area.
D
P
Q
P1
Q1
S

7. As we increase the quantity & reduce the price,
the total area of the consumer & producer
surpluses increases,
S
D
P
Q
P2
Q2

8. S
D
P
Q
P3
Q3
and increases,

9. until we reach the perfectly competitive
equilibrium.
S
D
P
Q
P*
Q*

10. We can not continue this process beyond that equilibrium
however.
S
D
P
Q
PS
PD
Q4
Output levels greater than the equilibrium will only be
purchased at prices below the equilibrium price, but they
will only be produced at prices above the equilibrium price.
So there is no price at which those output levels will be
produced & sold.

11. We have found that social welfare,
which equals
total consumer & producer surplus,
is maximized at the
perfectly competitive equilibrium.

12. How do we compare the social welfare
of two different situations?
1. Calculate the welfare from situation 1 by summing its
consumer surplus and producer surplus:
W1 = CS1 + PS1.
2. Calculate the welfare from situation 2 by summing its
consumer surplus and producer surplus:
W2 = CS2 + PS2.
3. Calculate the difference,
W2 – W1 = (CS2 + PS2) – (CS1 + PS1).
This tells us the gain or loss of welfare of one situation
relative to the other.
When a policy results in a loss of welfare to society,
that loss is often referred to as the deadweight loss.

13. Notice that we just calculated the social
welfare gain or loss as the difference in
combined consumer and producer surplus,
W2 – W1 = (CS2 + PS2) – (CS1 + PS1).
An alternative equivalent way is the following.
1. Calculate the change in consumer surplus:
ΔCS = CS2 – CS1 .
2. Calculate the change in producer surplus:
ΔPS = PS2 – PS1 .
3. Add to get the total gain or loss in social welfare:
ΔCS + ΔPS = (CS2 – CS1) + (PS2 – PS1)

14. Let’s explore the welfare effects of
some government policies.

15. Price Ceilings
S
D
P
Q
P*
Q*
Without the ceiling our consumer & producer
surpluses are as shown by the purple & green areas.

16. With price ceiling, Pc , the consumer & producer
surpluses are as shown.
S
D
P
Q
Pc
Qc

17. Consumers have lost area V but gained area U.
S
D
P
Q
Pc
Qc
U
V

18. The consumers who gain are those who get the product
at a lower price.
S
D
P
Q
Pc
Qc
U
V
The consumers who lose are those who are no longer
able to buy the product because there is less supplied.

19. In the graph shown, area U is larger than area V,
so consumers as a whole gain. However, if area
U is smaller than area V, consumers lose.
S
D
P
Q
Pc
Qc
U
V

20. Producers have lost areas U and W.
S
D
P
Q
Pc
Qc
U W

21. So area U just moved from producers to consumers,
but areas V and W were lost to everyone.
S
D
P
Q
Pc
Qc
W
V
U

22. Area V+W is the difference in the total consumer and
producer surplus with and without the policy
(CS2 + PS2) – (CS1 + PS1).
S
D
P
Q
Pc
Qc
W
V It is the deadweight
loss to society that
results from the policy.

23. Price Ceiling Example: Rent Controls
Suppose in the absence of controls, equilibrium rent would be
8 thousand dollars per year & equilibrium quantity would be
2 million apartments.
S
D
Rent
(thousands of
dollars per year)
Quantity of
apartments
(millions)
8
0 2.0

24. Next suppose that a price ceiling of 7 thousand dollars is
imposed. As a result the quantity supplied drops to 1.8 million.
S
D
Rent
(thousands of
dollars per year)
Quantity of
apartments
(millions)
8
7
0 1.8 2.0

25. Based on the graph, determine the effects
on consumers, producers, & society as a whole.
S
D
Rent
(thousands of
dollars per year)
Quantity of
apartments
(millions)
9
8
7
0 1.8 2.0

26. S
D
Rent
(thousands of
dollars per year)
Quantity of
apartments
(millions)
9
8
7
0 1.8 2.0
W
V
U
Recall that consumers gain area U and lose area V.
Producers lose areas U and W.

27. S
D
Rent
(thousands of
dollars per year)
Quantity of
apartments
(millions)
9
8
7
0 1.8 2.0
W
V
U
U = (1.8 million) (8,000 – 7,000) = $1,800 million
V = (1/2)(0.2 million)(1,000) = $100 million
W = (1/2)(0.2 million)(1,000) = $100 million

28. S
D
Rent
(thousands of
dollars per year)
Quantity of
apartments
(millions)
9
8
7
0 1.8 2.0
W
V
U
Consumers gain
U – V = $1,800 million - $100 million = $1,700 million.
Producers lose
U + W = $1,800 million + $100 million = $1,900 million

29. S
D
Rent
(thousands of
dollars per year)
Quantity of
apartments
(millions)
9
8
7
0 1.8 2.0
W
V
U
Producers lose $200 million dollars more than consumers gain.
So there is a deadweight loss of $200 million per year.

30. Are the effects of price floors
similar to those of price ceilings?
Let’s see.

31. Once again without the floor, consumer & producer
surpluses are as shown by the purple & green areas.
S
D
P
Q
P*
Q*

32. If a price floor of Pf is imposed, consumer & producer
surpluses are these purple & green areas.
S
D
P
Q
Pf
Qf

33. Consumers lose areas U & V.
S
D
P
Q
Pf
Qf
V
U

34. Producers gain area U & lose area W.
S
D
P
Q
Pf
Qf
U
W

35. Again the deadweight loss is area V+W .
S
D
P
Q
Pf
Qf
W
V

36. In the analysis that we just did,
we assumed that producers cut their output so that it
was just equal to Qf, the quantity demanded.
S
D
P
Q
Pf
Qf

37. However, it doesn’t always work that way.
In the case of agricultural price supports,
producers grow as much as they want
and the government buys the surplus.

38. At a price of Pf, producers will supply Qs.
S
D
P
QQd Qs
The resulting surplus is Qs – Qd, which is purchased by the
government with taxpayer money at price Pf.
This represents a cost to consumers of the gray rectangle T.
T
Pf
P*

39. Consumer surplus also falls by area U + V.
S
D
P
Q
Pf
P*
Qd Qs
So consumers lose a total of T + U + V .
U
V
T

40. Remember that producer surplus is the area under the price
and above the supply curve.
S
D
P
QQf
So producer surplus increases from the orange area
to the yellow area.
Pf
P*

41. The increase in producer surplus is the pink area.
S
D
P
QQf
Pf
P*

42. That gain to producers is much smaller than
the loss to consumers (T + U + V).
S
D
P
QQd Qs
U
V
T
Pf
P*
Therefore, as a
result of the price
floor, total social
welfare falls.

43. Next, we’ll examine the effect of
a sales tax.

44. Suppose a tax of $0.25 per unit is imposed on an item.
S
D
P
Q
1.50
50
From the consumer’s perspective, it is as if the supply
curve has shifted up vertically by the tax amount of $0.25.
S’
$0.25

45. The equilibrium quantity falls & the equilibrium price rises.
S
D
P
Q
1.50
40 50
Although the price rises, it does not rise by the full
amount of the tax.
S’
$0.25
$0.25

46. S
D
P
Q
1.65
1.50
1.40
40 50
S’
$0.25
The buyer pays (in this example) 15 cents more than before.
The seller gets 25 cents less than the buyer pays.
So the seller gets 10 cents less than before.

47. Consumer surplus falls by area U + V.
S
D
P
Q
V
S’
1.65
1.50
1.40
40 50
U

48. Producer surplus falls by area X + W.
S
D
P
Q
W
S’
1.65
1.50
1.40
40 50
X

49. S
D
P
Q
S’
1.65
1.50
1.40
0 40 50
X
U
Tax revenues equal the tax per unit times the number of
units sold.
So the area U + X is the government tax revenue.

50. S
D
P
Q
S’
1.65
1.50
1.40
0 40 50
V
WX
U
The total change in social welfare is the change in consumer surplus
[-(U + V)] plus the change in producer surplus [-(X + W)] plus the
government revenue (U + X), which equals
[-U - V] + [-X - W] + (U + X) = – V – W or – (V + W) .
The negative sign in front
of the V + W indicates
that it is a loss of V + W.

51. So area V + W is deadweight loss.
S
D
P
Q
S’
1.65
1.50
1.40
0 40 50
V
W

52. Next, we’ll examine the effects
of international trade
and of tariffs & quotas.

53. Domestic Demand Curve (DD ):
Demand for Cars by U.S. Consumers
quantity
DD
price

54. Domestic Supply Curve (SD ): Supply of
Cars to U.S. Consumers by U.S.
Producers
quantity
SD
DD
price

55. Without trade: price is P1 & quantity is Q1.
quantity
SD
DD
P1
O Q1
price

56. Without trade: consumer surplus is area A ...
quantity
SD
DD
P1
O Q1
A
price

57. ... and producer surplus is area B.
quantity
SD
DD
P1
O Q1
B
price

58. Total Supply Curve (ST ): Supply of Cars
to U.S. Consumers by All Producers
quantity
SD
DD
ST
Q1
P1
O
price

59. With trade: price is P2 and quantity
purchased by U.S. consumers is Q2.
quantity
SD
DD
ST
Q1 Q2
P1
P2
O
price

60. The quantity sold by U.S. producers is Q0
and the quantity of imports is Q2 – Q0.
quantity
SD
DD
ST
Q0 Q1 Q2
P1
P2
O
price

61. With trade: Consumer Surplus is area C
quantity
SD
DD
ST
P1
P2
O Q0 Q1 Q2
C
price

62. Recall: Without trade, consumer surplus
was area A.
quantity
SD
DD
ST
Consumers
have gained
area C-A
from trade.P1
P2
O Q0 Q1 Q2
A
C – A
price

63. Our concern is the welfare of U.S.
consumers and U.S. producers (not
foreign producers).
Domestic producer surplus is the area
above the domestic supply curve and
below the price.
Suppose we are viewing this issue from the
perspective of the U.S. government.

64. With trade: (Domestic) Producer Surplus
is area D.
quantity
SD
DD
ST
P1
P2
O Q0 Q1 Q2
D
price

65. Recall: Without trade, producer surplus
was area B.
quantity
SD
DD
ST
P1
P2
O Q0 Q1 Q2
B
price

66. Producers have lost area B – D from trade.
quantity
SD
DD
ST
P1
P2
O Q0 Q1 Q2
B - D
price

67. So consumers have gained area C – A ...
quantity
SD
DD
ST
P1
P2
O Q0 Q1 Q2
C – A
price

68. ... and producers have lost area B – D.
quantity
SD
DD
ST
P1
P2
O Q0 Q1 Q2
B - D
price

69. So for U.S. citizens, there is a net gain
from trade of area G.
quantity
SD
DD
ST
P1
P2
O Q0 Q1 Q2
G
price

70. Putting it all together:
Relative to the no-trade situation,
when there is free trade,
the price paid by U.S. consumers is lower.
the quantity purchased by U.S. consumers
is higher.
there is a gain in consumer surplus.
there is a loss of producer surplus.
there is a net gain to U.S. citizens or a gain
in total social welfare.

71. The net gain we just found was the gain from
free trade, that is, trade without tariffs or
quotas.
Let’s look now at the effect that quotas & tariffs
have on consumer & producer surplus.
In the analysis that follows, we assume that a single
country’s production of a good is small relative to
total world production. Therefore, the equilibrium
price of the good in the world as a whole is not
changed by the policy of a single country.
Suppose a tariff of t dollars is imposed on cars
imported to the U.S.

72. quantity
SD
DD
ST
P2
O Q0 Q1 Q2
price
Suppose a tariff of t dollars is imposed on cars imported to
the U.S.
The price of domestic cars in the U.S. will rise so that the
new price equals the pre-tariff price + the tariff t.
t
P2+ t

73. quantity
SD
DD
ST
P2+ t
P2
O
price
The total number of cars purchased by U.S. consumers will fall
to Q2’, the number of domestic cars purchased will rise to Q0’,
and the number of imported cars will fall to Q2’ – Q0’.
Q0 Q0’ Q1 Q2’ Q2

74. How will consumer &
domestic producer surplus change?

75. quantity
SD
DD
ST
P2+ t
P2
O
price
Consumer surplus will fall from this area
t
Q0 Q0’ Q1 Q2’ Q2

76. quantity
SD
DD
ST
P2+ t
P2
O
price
to this area
Q0 Q0’ Q1 Q2’ Q2

77. quantity
SD
DD
ST
P2+ t
P2
O
price
which is a loss of consumer surplus of this area.
t
Q0 Q0’ Q1 Q2’ Q2

78. quantity
SD
DD
ST
P2+ t
P2
O
price
Domestic producer surplus rises from this area
Q0 Q0’ Q1 Q2’ Q2

79. quantity
SD
DD
ST
P2+ t
P2
O
price
to this area
Q0 Q0’ Q1 Q2’ Q2

80. quantity
SD
DD
ST
P2+ t
P2
O
price
which is an increase in domestic producer surplus of this area.
Q0 Q0’ Q1 Q2’ Q2

81. quantity
SD
DD
ST
P2+ t
P2
O
price
Government revenues from the tariff are
the number of imports times the tariff per import,
which is this area.
t
Q0 Q0’ Q1 Q2’ Q2

82. quantity
SD
DD
ST
P2+ t
P2
O
price
The deadweight loss from the tariff is
the change in consumer surplus
+ the change in domestic producer surplus
+ the government tariff revenue.
Q0 Q0’ Q1 Q2’ Q2
So the deadweight
loss is the area of
these two triangles.

83. What is the effect of an import quota
instead of a tariff?
Suppose the government establishes a quota
of q .
Then the price of cars will rise until the
quantity supplied by domestic producers +
the import quota = the quantity demanded
by U.S. consumers.

84. quantity
SD
DD
ST
P3
P2
O
price
Suppose the quota is q = Q2’ – Q0’.
Q0 Q0’ Q1 Q2’ Q2
The new price will be P3.

85. quantity
SD
DD
ST
P3
P2
O
price
Again consumer surplus falls by this area.
t
Q0 Q0’ Q1 Q2’ Q2

86. quantity
SD
DD
ST
P3
P2
O
price
Domestic producer surplus increases by this area.
Q0 Q0’ Q1 Q2’ Q2

87. quantity
SD
DD
ST
P3
P2
O
price
However there is no additional government revenue.
So the deadweight loss from a quota is this area which is
greater than the deadweight loss from a comparable tariff.
Q0 Q0’ Q1 Q2’ Q2

88. We have shown that a perfectly competitive economy
maximizes the total net gain of consumers & producers.
We saw that deadweight losses (reductions in economic
efficiency) resulted if the government imposes a price
ceiling, price floor, import tariff or quota, or sales tax.
The general theme seems to be that the economy would
be better off if the government quit meddling & let
competitive markets alone.
This is frequently sound advice but not always.
There are often other objectives besides economic
efficiency to be considered (for example, equity or
fairness).
Also, there may be externalities involved.
In addition, sometimes markets are not competitive.