Maximising Consumer Surplus and Producer Surplus: How do airlines and mobile companies do it?

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1 Maximising onsumer Surplus and Producer Surplus: How do airlines and mobile companies do it? This is a topic that has many powerful applications in understanding economic policy applications: (a) the impact of many government interventions in the market and eg tariff protection eg import quotas eg taxes eg price control (b) market imperfections such as monopolies - price discrimination - monopoly pricing. Absolutely critical to understand the underlying logic.

2 First: Long Run Industry Supply urves, We have seen short run equilibrium under perfect competition What happens in the long run? What should the Long Run Supply curve look like? If you could predict what the Long Run Supply urve looks like for any commodity, and knowing likely demand (which is more predictable), you could make a fortune in the Futures market. In reality, despite many pre-conceptions, people have not been able to predict what the long term supply curves are going to be like, even for something as critical as oil (which we looked at in our last lecture)

3 Suppose that demand for a product increases from D1 to D2 In the short run, price rises from to P 1 ; super-profits are made, firms are attracted into the industry and the supply curve will therefore shift out. The question is: where will it shift to in the long run? And what will be the new equilibrium price? Higher? Lower? or the same? P ($) SRS 0 P 1 where? A D 2 D 1 qo q 1 L

4 Much depends on the markets for the inputs If input markets not perfectly competitive eg limited land or limited labour More firms buying inputs, pushes up the prices of these inputs for everyone, the AT curves rises for every firm; the SRS1 will not shift all that much, and the final equilibrium price will be higher than. A then represents the Long Run Supply urve for an increasing cost industry. Eg with rising population, what will happen to the long term price of food? P ($) SRS 0 AT 1 SRS 1 LRS 1 AT 0 P 1 A D 2 D 1 qo q 1

5 ut opposite may happen if there exist economies of scale Where all the firms, with higher outputs, begin to produce with lower minimum ATs (or all on the declining part of their AT curves) Which implies that the SRS1 has shifted so far to the right that equilibrium price P1 is less than. and the LRS 1 represents a decreasing cost industry with a downward sloping supply curve- i.e. the great boon of a decreasing cost industry. P ($) SRS 0 AT 0 SRS 1 A AT 1 P 1 D 2 LRS 1 D 1 qo q 1

6 Many examples in the electronics industry omputers: Forty years ago, a basic computer used to cost $500,000 and occupy a room 30 metres by 20 metres. There may have been perhaps 300,000 such computers in the world Today, desk-tops far more powerful, far more user-friendly (look at the menudriven word-processing, spread-sheets, databases, modeling soft-ware). Play Ds, DVDs, video-conferencing, electronic storage of everything,... Also connects you to the whole world : , Internet, persons, companies, libraries etc etc voice, video. illions of computers in the world, costing less than $2000 each. No end in sight to declining real costs and prices Similar arguments for televisions, radios, cameras, and mobiles etc

7 ut in-between normal case: horizontal supply curve If the input markets are perfectly competitive, then inputs can be bought for the same prices as originally regardless of how much of each input is purchased Which implies that all these firms will keep producing at the bottom of the AT curves ut there are now more firms, producing greater output Hence the supply curve shifts to SRS1, equilibrium output is at, and The line A represents the Long Run Supply urve for a constant cost industry. P ($) SRS 0 SRS 1 AT 0 P 1 A LRS 1 D 2 D 1 qo q 1

8 Hence for normal equilibrium under Perfect ompetition We have a horizontal supply curve; usual demand curve; With equilibrium quantity Qo; and Price = M i.e. economic efficiency i.e. in perfect competition equilibrium Marginal value to society = Marginal cost to society (no externalities) ut many consumers willing to pay more than : demand curve above : A $ A The value that society places on each extra unit of output The cost to society of producing that extra unit of output D S O Xo X

9 Definition of onsumer Surplus onsumer surplus exists wherever the price paid for one unit of a product by a consumer is less than what that consumers are willing to pay for it. If the price is, then the space (green lines: gap between the price line and the demand curve) represent the consumer surplus at each extra unit of output. Total consumer surplus is = the area A. $ A onsumer surplus at each output level? D O Xo X

10 If price changes eg to P 1 or P 2 then the consumer surplus changes If price rises to P1 then the consumer surplus declines to P 1 A. onversely if price declines to P2, then the consumer surplus increases to P 2 AE $ A P 1 E P 2 D O Xo X

11 Note the importance of demand elasticities If the demand is quite elastic (D 2 ): ie flatter, then a small rise in price leads to a large reduction in demand; ie. if fewer consumers who are willing to pay higher prices for this commodity: the consumer surplus is correspondingly smaller: area What would the consumer surplus be if the demand curve was completely flat? $ A D 2 D 1 O Xo X

12 Interesting applications from the sellers point of view If sellers can isolate all the buyers into their separate markets distinguished by what they are willing to pay: then they could charge those with higher consumer surplus, higher prices : And they could charge those with lower consumer surplus, lower prices. ie practice price discrimination; but the markets must be able to be kept separate Three examples: (a) Any common beverage (soft drinks or alcoholic) sold in a cafe as opposed to an up-market resort eg Fiji stubby: $2.50 in a hinese cafe, as opposed to $4.50 in the Holiday Inn. (b) Airline tickets; those who plan ahead; those who have to fly urgently; (c) mobile phone or land-line charges Does not require monopoly for this to happen (monopoly and price discrimination later).

13 How do airlines do it? Of course, airlines could compete with other airlines simply by reducing price- all would reduce price i.e. consumers would all be enjoying their consumer surplus. No gain to any airline. What do airlines actually do? Offer large discounts if you book in advance (airline gets confirmed sale, and cash in hand - hence reduced cash-flow problem) loser you get to the departure date, the higher is the price for those who have to travel. What do airlines have to do if departure date is getting closer and new bookings are not eventuating? (especially easy given that a lot of customers are now buying online) Sometimes just before a flight, the price drops, to fill empty seats Is it correct that all those who book early at the lowest price available, are those whose consumer surplus was the lowest? Do airlines give exactly the same kinds of discounts for every destination?

14 How do mobile and land-line companies extract consumer surplus? Explain why the phone companies can extract more consumer surplus by having different basic tariff rates for: (a) Distinguishing between pre-paid cards and post-paid cards (b) Different rates at different times of the day (c) Different rates for different destinations (d) different rates for different services: what are all the different services? (e) different groupings of customers? (f) differentiating commercial firms from ordinary firms.

15 Producer surplus Similar logic to consumer surplus analysis but with some subtle differences. Simplify by passing Supply urve through the origin We know that at each price level the Supply curve gives the output that the firm is willing to supply at the particular price. Anything received above that is a gain. So at price, the area above the supply curve and below the line, represents the total producer surplus enjoyed by the producer who is producing at output point Xo. (O) $ S = sum of M curves D O Xo X

16 Producer surplus: is not money in the pocket of the producers Industry revenue = area OXo. The area under the supply curve = sum of the industry Ms = Total Variable ost. The industry increases output as long as MR = P > M (which is represented by the Supply curve: so everywhere, the net gain to the producer = P - M ut of course he also has to pay his Fixed osts Real Net profit = OXo - OXo - Total Fixed costs = Producer surplus O - Total Fixed costs $ S = sum of M curves D O Xo X

17 Producer surplus: total marginal gain of producing more This marginalist reasoning about producer surplus is at the heart of marginal analysis; once the fixed investments are made (Total Fixed osts) What matters for economic efficiency and the decision on the optimum amount to produce is whether producing and selling one more unit will be such that MR > M and here MR = P > M i.e only whether the price line is above the Supply curve. Fascinating application to efficiency pricing of a good produced by a state enterprise in a situation where Marginal ost is virtually 0 : the price should be zero.

18 Total Surplus : maximum at equilibrium price And with Pareto Optimality in General Equilibrium Total Surplus = onsumer Surplus + Producer Surplus = + O. Under perfect competition, this Total Surplus is the maximum available to the economy. $ S = sum of M curves D O Xo Q

19 Any other output level, will lead to a lower Total Surplus Suppose the firm (for whatever reason, chooses to produce at lower output X1 New consumer surplus = EP1 New producer surplus = OAEP1 Total Surplus has shrunk by EA: called the deadweight loss to the economy. $ P 1 E S = sum of M curves F A D O X 1 Xo X

20 ut note by how much consumer surplus has declined by onsumer surplus has declined by P 1 E ut of this, one bit has been gained by the producers: P 1 EF Where has FE gone to? The net change in producer surplus = - FA + P 1 EF Will this be positive or negative? Where has AF gone to? i.e. AFE = FE + AF =????? $ P 1 E S F A D O X 1 Xo Q

21 Note that in neoclassical economics The transfer of surplus from consumers to producers or from producers to consumers is NOT seen as positive or negative, either way. It is seen as merely a transfer within society. Whether the producer is rich or poor, or the consumers are rich or poor. For Neoclassical Economics, there is no value judgment made about an extra dollar in the hands of a producer (even if he is a monopolist, rich or poor) or in the hands of a consumer What if for a PI, the producers are companies (foreign or local) who invest overseas? What if the consumers are foreigners? an they be?

22 Suppose govt imposes price control: ie a price ceiling? What will be new output? X1 or X2? What will be the new consumer surplus? smaller or bigger than before? What will be the new producer surplus? smaller or bigger than before? What is the total surplus? bigger or smaller than before? What is the dead-weight loss? Has the economy gained or lost overall? Who gained? Who lost? $ S = sum of M curves A P 1 F E D O X 1 Xo X 2 Q

23 What if government decrees that output must increase to X2 and must be sold at price P1? What happens to producer surplus, producing at X2? The increase in consumer surplus = P1F Where does this increase in consumer surplus come from? Why is output point X2 so inefficient from society s point of view? What is a neat geometric expression representing this deadweight loss? $ G S = sum of M curves P1 F D O Xo X 2 Q

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