Question

Consider the following examples and discuss how trades create value.

(a) Patrick bought an orange pen from Jill for $2.00. Patrick would have been willing to pay $2.50 for the pen, and Jill would have been willing to sell the pen for $1.25.

(b) Hillary found a car on Craigslist and she is willing to pay up to $10,000. The car’s owner Jason would be willing to sell it for $6,000. They agreed on a price of $7,500.

Answer 1

(a)

The trade creates value by making both the parties to the transaction better-off.

The value created for buyer is termed as consumer surplus whereas the value created for seller is termed as producer surplus.

The sum total of the consumer surplus and the producer surplus is the total economic surplus.

So, the total value created by the trade is equal to the total economic surplus created by the trade transaction.

Patrick was willing to pay $2.50 for the pen. He bought the pen for $2.00.

Consumer surplus earned by Patrick = Maximum willingness to pay for the pen - Actual amount paid for the pen

Consumer surplus earned by Patrick = $2.50 - $2.00 = $0.50

The consumer surplus earned by Patrick is $0.50.

Jill would be willing to accept $1.25 for the pen. She sold pen for $2.00.

Producer surplus earned by Jill = Actual amount received for the pen - Minimum willingness to pay for the pen

Producer surplus earned by Jill = $2.00 - $1.25 = $0.75

The producer surplus earned by Jill is $0.75.

Calculate the total economic surplus -

Total economic surplus = Consumer surplus + Producer surplus = $0.50 + $0.75 = $1.25

The total economic surplus is $1.25

Thus,

The total value created by trade is $1.25

(b)

The trade creates value by making both the parties to the transaction better-off.

The value created for buyer is termed as consumer surplus whereas the value created for seller is termed as producer surplus.

The sum total of the consumer surplus and the producer surplus is the total economic surplus.

So, the total value created by the trade is equal to the total economic surplus created by the trade transaction.

Hillary was willing to pay up to $10,000 for the car. She actually paid $7,500.

Consumer surplus earned by Hillary = Maximum willingness to pay for the car - Actual price paid for the car

Consumer surplus earned by Hillary = $10,000 - $7,500 = $2,500

The consumer surplus earned by Hillary is $2,500.

Jason is willing to sell his car for $6,000. He actually sold his car for $7,500.

Producer surplus earned by Jason = Actual price received for the car - Minimum price acceptable for the car

Producer surplus earned by Jason = $7,500 - $6,000 = $1,500

The producer surplus earned by the Jason is $1,500.

Calculate the total economic surplus -

Total economic surplus = Consumer surplus + Producer surplus

Total economic surplus = $2,500 + $1,500 = $4,000

The total economic surplus is $4,000.

Thus,

The total value created by trade is $4,000.