Question

Your neighbor never mows her lawn. You don't have any legal right to force her to mow, but the mess in her front yard is making your neighborhood unsightly and reducing the value of your house. The reduction in the value of your house is \(\$ 5,000\), and the value of her time to mow the lawn once a week is \(\$ 1,000\). Suppose you offer her a deal in which you pay her \(\$ 3,000\) to mow. How does this deal affect surplus? [LO 18.4] a. The deal increases only your surplus. b. The deal increases only your neighbor's surplus. c. The deal increases both your surplus and your neighbor's. d. The deal increases your surplus but decreases your neighbor's. e. The deal increases your neighbor's surplus but decreases yours. f. The deal does not affect surplus.

Short answer

c. The deal increases both your surplus and your neighbor's.

Step-by-step solution

Define Surplus

Consumer surplus is the difference between what consumers are willing to pay and what they actually pay. Producer surplus is the difference between what producers receive and the minimum amount they would accept. In this problem, consider the surplus changes for both you and your neighbor.

Calculate Your Original Situation

Initially, your house's value is reduced by \(5,000\), and because you cannot legally force your neighbor to mow, your consumer surplus remains negative \(5,000\).

Evaluate the Proposed Deal for You

If the neighbor mows the lawn, your house's value no longer decreases by \(5,000\). You pay \(3,000\) to her. Therefore, your new consumer surplus is \((5,000 - 3,000) = 2,000\).

Analyze the Neighbor's Original Situation

The neighbor initially spends \(0\) on mowing, valuing their time at \(1,000\) per mow, resulting in zero surplus since they are not spending time mowing.

Evaluate the Proposed Deal for Your Neighbor

With your \(3,000\) payment, your neighbor receives \(3,000\) but incurs a cost from time valued at \(1,000\). Their new surplus is \((3,000 - 1,000) = 2,000\).

Determine Change in Total Surplus

Adding the new surpluses, your surplus has improved by \(2,000\) and your neighbor's by \(2,000\), resulting in a total increase in surplus of \(4,000\). Both parties benefit, satisfying the condition of Pareto improvement.

Key concepts

Producer Surplus

Producer surplus represents the additional benefit producers receive when they sell a good at a price higher than their minimum acceptable price. In this scenario, your neighbor is the producer because they possess the capability to mow the lawn. Initially, there is no producer surplus for your neighbor, as they are not mowing and, therefore, earning nothing from this activity.

However, when you propose the offer of $3,000, the situation changes. Your neighbor's cost, or the value of their time for mowing, is $1,000. Since they accept your offer, they receive a payment of $3,000 for an activity they evaluate at only $1,000. This means they gain $2,000 more than their minimum requirement. Therefore, their producer surplus increases by $2,000.

In essence, producer surplus is a way to measure how much better off the seller becomes due to a favorable transaction price. Here, it highlights the advantage your neighbor gains by agreeing to mow the lawn.

Pareto Improvement

A Pareto improvement describes a situation where at least one party benefits without making any other party worse off. This concept is essential in evaluating whether changes in a transaction result in an overall enhancement of well-being.

By offering your neighbor $3,000 to mow the lawn, both of you experience a benefit. You avoid the devaluation of your property, increasing your consumer surplus by $2,000. Simultaneously, your neighbor gains $2,000 in producer surplus, as previously described. Since both parties achieve an increase in their respective surpluses, neither one is worse off following the deal.

• You regain $2,000 (from your house no longer depreciating by $5,000 and the $3,000 payment).
• Your neighbor earns $2,000 more by mowing.

Thus, the agreement satisfies the conditions for a Pareto improvement because both participants end up in a more favorable position without anyone incurring a loss.

Economic Surplus

Economic surplus is the sum of consumer and producer surplus, serving as an indicator of the total benefits to society from a transaction or economic activity.

Prior to the offer, your economic situation results in a negative consumer surplus of $5,000 due to your property's reduced value. Your neighbor has no producer surplus as they are not being compensated for mowing. Therefore, the initial economic surplus is non-existent or considered zero when neglecting any unfavorable factors.

Once you propose the $3,000 payment deal, both your consumer surplus and your neighbor's producer surplus improve by $2,000 each. This results in a total increase in economic surplus of $4,000, reflecting the positive impact of the deal as it benefits both parties. Economic surplus effectively measures the overall gain from trade or transactions, emphasizing efficiency and benefit enhancement in economic exchanges.