Assume the world market for bananas is competitive and that the marginal cost of producing a case of bananas is $12.50 and the marginal benefit is $15. If one more case of bananas is produced and consumed, how will the economic surplus change?
To answer this question, let’s first discuss what we mean by economic surplus. Economic surplus is the sum of consumer surplus and producer surplus. Consumer surplus is the difference between the highest price a consumer is willing to pay for a good or service and the actual price the consumer pays. In other words, consumer surplus measures the benefit to consumers. Producer surplus is the difference between the lowest price a firm would be willing to accept for a good or service and the price it actually receives. This means that producer surplus measures the benefit to producers from participating in a market (in this case, the market for bananas).
This question also mentions a few other terms we need to understand. The marginal benefit is the additional benefit to a consumer from consuming one more unit of a good or service. In this case, we have been told that the marginal benefit is $15. The marginal cost is the additional cost to a firm of producing one more unit of a good or service. In this case, we have been told that the marginal cost of producing a case of bananas is $12.50.
One other note I should mention here is that equilibrium in a competitive market results in the economically efficient level of output; this is where marginal benefit equals marginal cost. In this sample problem, we know the market is not in equilibrium because the marginal benefit does not equal the marginal cost. In this example the market is experiencing deadweight loss, which is the reduction in economic surplus resulting from a market not being in competitive equilibrium.
One other important concept to note is that, in this example, the marginal benefit exceeds the marginal cost. This means that with each additional case of bananas produced, the economic surplus will rise as we move toward equilibrium. Competitive equilibrium is the most efficient point and gains in economic surplus will be made until equilibrium is reached.
So, now we know that economic surplus is increasing…but by how much? As you can see in the chart below, consumer surplus is the area between the demand curve and the equilibrium (market) price. The producer surplus is the area between the supply curve and the equilibrium (market) price.
As I mentioned earlier, economic surplus is the sum of consumer surplus and producer surplus. This is where some confusion may arise since we don’t have enough information in this problem to find the total consumer or producer surplus. That’s OK, for this example we are only asked to solve for the change in economic surplus at the margin (for one more case of bananas). We don’t know what the market price is so we can’t tell where the consumer surplus ends and where the producer surplus begins, but we do know that the difference between marginal benefit ($15) and the marginal cost ($12.50) is $2.50. Thus, the economic surplus will increase by $2.50, as one more case of bananas is produced.
If you have any questions on this sample problem or any of these concepts, please post them to this thread.
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