We've learned that demand curves show us willingness to pay, or marginal benefit, and that in a competitive market, supply curves show us willingness to accept, or marginal cost. An equilibrium exists at the price and quantity where there's no tendency to change. And we talked about how that's where marginal benefit equals marginal cost. Let's really dive into what all that means and what it tells us about how voluntary exchange makes everyone better off.
We know based on the intersection of supply and demand in the taco market that equilibrium price and quantity are here. We'll say that's 3. And we know that if the price was higher, there'd be a surplus with more tacos for sale than people want and prices will fall. If the price is lower, then more people want tacos than are available and the price would rise.
Remember, when marginal benefit is greater than marginal cost, there are gains from trade. You're willing to pay $4 for a taco. and someone is willing to sell it to you for $2. If the price is $3, you're both better off. You get something that was worth $4 to you that you only paid $3 for, and they'd rather have $3 than the cost of the taco to them, which was $2.
Let's quantify those gains from trade for the entire market, starting with consumers and the demand curve, the marginal benefit curve. Consumers benefit from these voluntary exchanges is the difference between their willingness to pay and what they had to pay, which is the price. In this market, the person most willing to pay a taco to buy a taco is willing to pay seven dollars for it. That's the marginal benefit of the first taco.
But they only pay three dollars for it. This is their consumer surplus. The consumer surplus is $4. The difference between how much they wanted it, their marginal benefit, that's $7, and what they had to pay for it, the price of $3.
If you've ever said, I'm so hungry I would have paid $20 for that taco, but you only paid $3, that's consumer surplus. Let's take someone else on this demand curve whose marginal benefit is lower, someone who's only willing to pay $6. They get $3 of consumer surplus.
The $6 they were willing to pay minus the $3 they had to pay. That's how much better off they are. We could do that for someone willing to pay $5 or $4. And we know that the person who was willing to pay $3 got zero consumer surplus because their willingness to pay exactly equaled the price that they paid.
We're going to assume that they bought it. but they were just indifferent between buying and not buying. Now, there are no sales over here because this person was only willing to pay $2.50 for the taco, but the price is $3, so they didn't buy it.
So, how do we add up everyone's consumer surplus? It's the difference between the demand curve and the price. The area between the demand curve and the price, which in this case is a triangle. The area of a triangle is one half base times height. The base here is the total quantity sold, 100 tacos.
The height is the difference between the maximum willingness to pay, $7, and the price, $3, which equals 4. One half. the base of 100 tacos times the height of four dollars per taco. Multiplying these together equals $400 times one half because we're just looking at the triangle, which equals $200 of consumer surplus.
That's a measure of how much better off consumers are because of the taco market at this price. If the equilibrium price was higher, then consumer surplus would be lower because the difference between willingness to pay and price would be smaller. But consumer surplus is the benefit that you get from the market. Price plays a role, but what something is worth is not determined by the price.
It's determined by willingness to pay how much you want it. And that takes us back to the diamond water paradox from the beginning of the course. If you had no water at all, you'd be willing to pay a huge amount for the first gallon.
But instead, you don't have to pay very much at all. Your consumer surplus from that first gallon is enormous and probably the first few dozen gallons. The marginal benefit from the last gallon of water is pretty small, and if the price went up a bit, you'd probably cut back on your use.
Draw parallels with your day-to-day decisions to understand how thinking on the margin, willingness to pay, and consumer surplus make you better off.