Consumer and Producer Surplus, Utility, and Cost Concepts
Consumer and Producer Surplus
Consumer surplus is the difference between the maximum price a consumer is willing to pay and the actual price they pay. When the marginal benefit (MB) exceeds the marginal cost (MC), there is an under-allocation of resources. One of the key characteristics of private goods is rivalry, meaning that when one person buys and consumes a product, it is not available for another person. Increases in price reduce consumer surplus. Consumer surplus is always graphically represented above producer surplus.
Producer surplus is the difference between the actual price a producer receives and the minimum acceptable price that a consumer would pay. The combined consumer and producer surplus is maximized when the market achieves allocative efficiency. Deadweight losses occur at quantities other than the competitive equilibrium quantity.
Characteristics of Private Goods
The two main characteristics of private goods are:
- Rivalry
- Excludability
Products yielding positive externalities will tend to be under-produced in a competitive economy. A graph of a good generating negative externalities shows the point of the triangle inward. A graph of a positive externality is represented under the top line with the point towards the right.
Marginal Utility and Consumer Behavior
Marginal utility is the extra satisfaction a consumer realizes from an additional unit of a product. Price changes affect the marginal utility per price (MU/P) ratio; the price can affect the utility of a unit by rising or falling.
Utility Maximization
Utility is maximized for a consumer under indifference curve analysis when the budget line is tangent to the highest attainable indifference curve. The difference between diminishing marginal utility and diminishing marginal returns is that marginal utility refers to the benefit, while marginal returns refer to production.
Total utility is the total amount of satisfaction a person derives from consuming a specific quantity of a product. Diminishing marginal utility begins in a table when total utility (TU) is rising at a decreasing rate. Total utility is maximized when marginal utility is zero.
Two rules for a consumer to maximize their satisfaction are:
- The consumer must spend all their income (consumer assumption).
- The consumer must choose the combination of goods that equates the marginal utility per dollar spent on each good (utility maximization).
Having to pay less than the full cost of consuming a good or service encourages consumers to use more of this good or service than they ordinarily would.
Marginal Rate of Substitution
The marginal rate of substitution (MRS) shows the rate at which a consumer must substitute one good for another while maintaining the same level of satisfaction. The marginal rate of substitution of good X for good Y tells one how much of good Y can replace good X without satisfaction decreasing. At various points on the budget line in the indifference curve utility-maximizing analysis, the budget line is downward sloping, and the indifference curves are convex to the origin.
Costs and Production
Average fixed costs decline as output increases. A major source of economies of scale is the increased specialization of labor.
Implicit Costs
Implicit costs are the opportunity costs of using the resources that a firm already owns to make its product rather than selling those resources to outsiders for cash. Normal profits constitute an implicit cost for economists.
Short Run vs. Long Run
The short run is a period too brief for a firm to alter its plant capacity (fixed plant) but long enough to change the degree to which the plant’s current capacity is used. The long run is a period long enough for a firm to adjust the quantities of all resources it employs, including plant capacity (variable resources).
Marginal Product
The marginal product (MP) of a resource is calculated as:
MP = Change in Total Output / Change in Labor Input
Total product begins to fall when marginal product becomes negative. Diminishing marginal product begins when MP reaches its maximum. When MP is greater than average product (AP), AP will start to increase.