Teaching Guide: Economic Surplus

Learning Objectives

After completing this lesson, you will be able to:

  • Define reservation price
  • Calculate consumer surplus and producer surplus

Most day-to-day shopping activities don’t include haggling or any form of negotiation. It’s common for stores to price a product based on their understanding of consumer demand, and it’s up to the customer to determine if the want to purchase the item at that price. Occasionally, people do enter situations where bargaining is more common.

In the scene below, Mateo has been injured on the job and his employer is interested in paying him to avoid a lawsuit. Mateo turns down the offer, not because he wants to sue Cloud 9, but rather because he’s undocumented and doesn’t have a social security number, which is required for the paperwork. Mateo gets into a back-and-forth with the regional manager (Jeff) and we learn just how much Cloud 9 is willing to pay Mateo for his silence:

Reservation Prices

Let’s assume instead that Mateo is willing and able to sign away his right to legal recourse. At the start of the scene, he mentions how he is upset that he has to “walk away from $1,000” which implies he was willing to accept that price. A reservation price is the lowest price that someone is willing and able to sell their products/services for. In the case of Mateo, he may have even been willing to go lower, but we don’t know. We’ll assume $1,000 is his reservation prices for later sections.

Luckily, students play this sort of game all the time, even if they’ve never had a job. A common sleep-over activity involves a game of “how much would you need to be paid” listings. Have students volunteer to sing Karaoke in front of the class (Geerling & Mateer 2015), but try to simultaneously elicit their reservation price for singing. If you are careful with data collection, you can even build a supply curve!

Economic Surplus

Even though we aren’t able to find the agree upon price in the clip above, we can still use some assumptions to identify economic surplus. Jeff represents Cloud 9 and has kept close their actual willingness to pay for Mateo’s silence. Getting Mateo to sign for a lower price, like $1,000 would result in a large amount of consumer surplus. As prices rise, because they’re willing to pay more than $1,000, their consumer surplus shrinks. For Mateo, the difference between his reservation price and the price he’ll be paid is his producer surplus since he’s “producing” silence.

Assume that Jeff’s final offer represents Cloud 9’s actual willingness to pay for Mateo’s silence. Have students calculate Mateo’s producer surplus and Cloud 9’s consumer surplus if they had been able to meet somewhere in the middle, like $4,000.

Suggested answers:
Cloud 9’s consumer surplus is their maximum willingness to pay ($15,000) less the actual amount they pay ($4,000). In ths scenario, they would earn $11,000 of surplus.

If Mateo’s reservation price was $1,000 and he was able to settle for $4,000 then he would earn $3,000 worth of producer surplus.

The total economic surplus for this transaction would come to $14,000.