Economists normally assume people's preferences should be

Read and consider the “Willingness to Pay” example in Section 7-1 (Chapter 7 Section 1).

Now find and evaluate the willingness to pay, consumer surplus, demand, producer surplus, cost and willingness to sell of your own example. (products to consider: online ticket sales to sporting events, Vegas shows, eBay products, etc).

Chapter 7

7-1 Consumer Surplus

We begin our study of welfare economics by looking at the benefits buyers receive from participating in a market.

7-1a Willingness to Pay

Imagine that you own a mint-condition recording of Elvis Presley’s first album. Because you are not an Elvis Presley fan, you decide to sell it. One way to do so is to hold an auction.

willingness to pay the maximum amount that a buyer will pay for a good

Four Possible Buyers’ Willingness to Pay Four Elvis fans show up for your auction: Taylor, Carrie, Rihanna, and Gaga. They would all like to own the album, but each of them has a limit on the amount she is willing to pay for it. Table 1 shows the maximum price that each of the four possible buyers would pay. A buyer’s maximum is called her willingness to pay, and it measures how much that buyer values the good. Each buyer would be eager to buy the album at a price less than her willingness to pay, and she would refuse to buy the album at a price greater than her willingness to pay. At a price

TABLE 1

Four Possible Buyers’ Willingness to Pay Buyer Willingness to Pay

Taylor $100

Carrie 80

Rihanna 70

Gaga 50

equal to her willingness to pay, the buyer would be indifferent about buying the good: If the price is exactly the same as the value she places on the album, she would be equally happy buying it or keeping her money.

To sell your album, you begin the bidding process at a low price, say, $10. Because all four buyers are willing to pay much more, the price rises quickly. The bidding stops when Taylor bids $80 (or slightly more). At this point, Carrie, Rihanna, and Gaga have all dropped out of the bidding because they are unwilling to bid any more than $80. Taylor pays you $80 and gets the album. Note that the album has gone to the buyer who values it most highly.

What benefit does Taylor receive from buying the Elvis Presley album? In a sense, Taylor has found a real bargain: She is willing to pay $100 for the album but pays only $80. We say that Taylor receives consumer surplus of $20. Consumer surplus is the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it.

Consumer surplus measures the benefit buyers receive from participating in a market. In this example, Taylor receives a $20 benefit from participating in the auction because she pays only $80 for a good she values at $100. Carrie, Rihanna, and Gaga get no consumer surplus from participating in the auction because they left without the album and without paying anything.

Now consider a somewhat different example. Suppose that you had two identical Elvis Presley albums to sell. Again, you auction them off to the four possible buyers. To keep things simple, we assume that both albums are to be sold for the same price and that no one is interested in buying more than one album. There-fore, the price rises until two buyers are left.

In this case, the bidding stops when Taylor and Carrie bid $70 (or slightly higher). At this price, Taylor and Carrie are each happy to buy an album, and Rihanna and Gaga are not willing to bid any higher. Taylor and Carrie each receive consumer surplus equal to her willingness to pay minus the price. Taylor’s consumer surplus is $30, and Carrie’s is $10. Taylor’s consumer surplus is higher now than in the previous example because she gets the same album but pays less for it. The total consumer surplus in the market is $40.

7-1b Using the Demand Curve to Measure Consumer Surplus

Consumer surplus is closely related to the demand curve for a product. To see how they are related, let’s continue our example and consider the demand curve for this rare Elvis Presley album.

We begin by using the willingness to pay of the four possible buyers to find the market demand schedule for the album. The table in Figure 1 shows the demand schedule that corresponds to Table 1. If the price is above $100, the quantity demanded in the market is 0 because no buyer is willing to pay that much. If the price is between $80 and $100, the quantity demanded is 1 because only Taylor is willing to pay such a high price. If the price is between $70 and $80, the quantity demanded is 2 because both Taylor and Carrie are willing to pay the price. We can continue this analysis for other prices as well. In this way, the demand schedule is derived from the willingness to pay of the four possible buyers.

Figure 1 Graph will not copy

The graph in Figure 1 shows the demand curve that corresponds to this demand schedule. Note the relationship between the height of the demand curve and the buyers’ willingness to pay. At any quantity, the price given by the demand curve shows the willingness to pay of the marginal buyer, the buyer who would leave the market first if the price were any higher. At a quantity of 4 albums, for instance, the demand curve has a height of $50, the price that Gaga (the marginal buyer) is willing to pay for an album. At a quantity of 3 albums, the demand curve has a height of $70, the price that Rihanna (who is now the marginal buyer) is willing to pay.

Because the demand curve reflects buyers’ willingness to pay, we can also use it to measure consumer surplus. Figure 2 uses the demand curve to compute consumer surplus in our two examples. In panel (a), the price is $80 (or slightly above) and the quantity demanded is 1. Note that the area above the price and below the demand curve equals $20. This amount is exactly the consumer surplus we computed earlier when only 1 album is sold.