Minimum and maximum prices, Consumer and producer surplus

Question 1

What is consumer surplus?

Answer 1

The difference the price at which a consumer is willing pay and the price they actually pay. It’s a measure of consumer welfare.

Question 2

How do you work out total consumer surplus using the diagram?

Answer 2

Total consumer surplus is the area of the triangle shaded.

Question 3

What is producer surplus?

Answer 3

Producer surplus is the difference between the price a supplier willing to accept and the market price they actually received. It is a measure of producer welfare.

Question 4

How do you work out the total producer surplus using the diagram?

Answer 4

Total producer surplus is the area of the triangle.

Question 5

What is the sum of consumer and producer surplus called?

Answer 5

Community surplus.

Question 6

At what point on the diagram is community surplus maximised?

Answer 6

The market equilibrium is the point community is maximised.

Question 7

What would happen community surplus if production were to take place before Qe?

Answer 7

There would be a loss of community surplus.

Question 8

What is the point of allocative efficiency?

Answer 8

The point where supply and demand meet, it reflects the output and price combination that is optimal from the point of view society as a whole.

Question 9

What can supply be labelled as on the diagram?

Answer 9

Marginal social cost.

Question 10

What can demand be labelled as on the diagram?

Answer 10

Marginal social benefit.

Question 11

Why do we label supply curve as a marginal social cost curve?

Answer 11

Supply is related to a firms costs so an industry supply curve in a product market could be thought of as equal to the costs to society of making that good. Therefore, a supply curve is social cost curve. Marginal in economics means producing one more unit. So a supply curve represents the costs to society of producing one more unit.

Question 12

Why do we label the demand curve as a marginal social benefit curve?

Answer 12

The demand is curve is determined by the utility, or benefits, that the consumption of a good can bring to society. The demand curve represents the benefit to society of consuming one more unit of a particular unit good. So it is labelled as the marginal social benefit.

Question 13

What is community welfare?

Answer 13

Community welfare is often used to evaluate the welfare effects i.e. the impact on society of a particular policy or action.

Question 14

What happens if production is before Qe (welfare analysis)?

Answer 14

Due to loss of output producer and consumer surplus has been lost. This loss is called deadweight loss i.e. it has been lost to the whole of society.

Question 15

What is minimum price?

Answer 15

The government sets a price below which the good cannot fall. These are sometimes called floor prices.

Question 16

Why do governments set floor prices/ minimum prices?

Answer 16

This is scheme is often used by governments to guarantee a certain price for agricultural commodities and thus guarantee farmers of those commodities a minimum income to motivate them to stay in the agricultural market.

Question 17

How is minimum price set?

Answer 17

minimum price is set above the price equilibrium to reduce demand.

Question 18

What are the effects of setting a minimum price?

Answer 18

1) A minimum price could hold the price artificially high thus reducing consumer demand of an important commodity.

2) Buying excess supply can create ‘mountains’ of stocks that people dont want. Controversially, some governments have ‘dumped’ surplus agricultural stock on less economically developed countries (LEDCs) at very low prices. This can then put local farmers in these much poorer countries out of work as they cannot compete with the low prices of the ‘dumped’ stock. In this example, the worlds poorest countries are then paying the price to support the incomes of rich world farmers.

3) To prevent the above, the government may try to get farmers to cut back production. One way for them do this would be able to pay the farmers to produce less.

Question 19

Why don’t we set the minimum price below the price equilibrium?

Answer 19

The minimum price will have no effect on the market price if it is set below Pe as if it is set below Pe as although prices will not fall below the Pmin there is nothing to stop prices going above Pmin so prices will eventually settle at free market equilibrium.

Question 20

How can we use welfare analysis to analyse the impact of minimum prices on market participants?

Answer 20

We can use the original consumer ABP surplus and the original producer surplus BCP. So the community surplus before the imposition of the minimum price ABC. Once the minimum price is imposed, the higher the price the consumer has to pay reduces consumer surplus from the original ABP to the much smaller ADE. The area DEFP that used to be consumer surplus is now producer surplus. The new producer surplus is therefore, CDEG. The area EBG used to be consumer surplus is now producer surplus