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Lesson Overview: Consumer and Producer Surplus

This lesson introduced the basics of a branch of economics known as welfare economics, which is interested in how the allocation of resources affects wellbeing. The most important concepts used in welfare analysis are total surplus and allocative efficiency
  • The total surplus in a market is a measure of the total wellbeing of all participants in a market. It is the sum of consumer surplus and producer surplus.
  • Consumer surplus is the difference between willingness to pay for a good and the price that consumers actually pay for it. Each price along a demand curve also represents a consumer's marginal benefit of each unit of consumption. The difference between a consumer's marginal benefit for a unit of consumption, and what they actually pay, represents how much benefit a consumer get's from the price they are paying.
  • Producer surplus represents the difference between the price a seller receives and their willingness to sell for each quantity. Each price along a supply curve also represents a seller's marginal cost of producing each unit of production. Therefore the difference between what the price that the seller for each unit, and what it cost for the seller to produce that last unit, represents the seller's benefit from the price they are getting.
  • Total welfare is maximized when a market produces at its equilibrium price and quantity. This level of output is considered allocatively efficient because no other price and quantity combination can achieve a greater level of total surplus.

Total Surplus and Allocative Efficiency

Consumer and producer surplus together represent the total surplus, or total welfare in a market. Total welfare is the total extra benefit or happiness enjoyed by producers and consumers who feel they got a good price for the product being exchanged (paid less than they were willing to pay or received more than they were willing to accept).
The total welfare in a market is the combined areas of consumer surplus and producer surplus.
In the market for oranges above, the total welfare is the sum of the green and the red areas.
A market producing at equilibrium is achieving allocative efficiency, meaning that resource are allocated in the best possible manner to maximize total welfare among consumers and producers. Allocative efficiency is achieved when the price in the market equals the marginal benefit (M, B) and the marginal cost (M, C).
At any other price and quantity combination, the market would be allocatively inefficient, and the M, B, does not equal, M, C.
In the market above, the price and quantity supplied of oranges are lower than at equilibrium (dollar sign, 3 and 2000 pounds). The price consumers are willing to pay for the 2000, t, h pound of oranges (the M, B) is greater than the cost of producing the 2000, t, h pound (the M, C).
M, B, equals, dollar sign, 7, is greater than, M, C, equals, dollar sign, 3.
The market is allocatively inefficient because consumers are willing to pay more than it costs producers to grow 2000 pounds of oranges. More resources should be allocated towards orange production.
The deadweight loss from the underproduction of oranges is represented by the purple (lost consumer surplus) and orange (lost producer surplus) areas on the graph.
In the market above the price and quantity supplied of oranges are greater than at equilibrium (dollar sign, 7 and 6, comma, 000 pounds). The price consumers are willing to pay for the 6000, t, h pound of oranges (the M, B) is less than the cost of producing the 6000, t, h pound (the M, C)
M, B, equals, dollar sign, 3, is less than, M, C, equals, dollar sign, 7
The market is allocatively inefficient because it costs producers more to produce 6000 pounds of oranges than consumers are willing to pay. Fewer resources should be allocated towards orange production.
The deadweight loss from the overproduction of oranges is represented by the purple (lost consumer surplus) and orange (lost producer surplus) areas on the graph.

Key terms

TermDefinition
Consumer surplusThe welfare or benefit enjoyed by consumers who pay a price lower than the price they would have been willing to pay. Graphically the area below the demand curve and above the price in the market
Producer surplusThe welfare or benefit enjoyed by producers who sell for a price higher than the price they would have been willing to sell for. Graphically the area above the supply curve and below the price in the market
Total welfare (total surplus or community surplus)The sum of consumer and producer surplus. Represents the total monetary benefit of consumers and producers who feel they got a good price for a product
Allocative efficiencyWhen market output occurs at a quantity and price at which M, B, equals, M, C. Neither too much nor too little is produced, and resources are allocated efficiently
Allocative inefficiencyWhen a market is allocatively inefficient, the M, B, does not equal, M, C at the prevailing price and quantity combination. Either too much or too little of the good is being produced
Deadweight loss (DWL)DWL is the loss of total welfare resulting from a market producing at an allocatively inefficient price and quantity combination

Key calculation

Consumer and producer surplus can be calculated as areas on a demand and supply graph. The value used to describe total surplus is generally dollars, essentially quantifying the extra welfare in a market in terms of how much money consumers and producers feel like they have saved or earned through an exchange.
Consumer and producer surpluses are calculated as the areas of the triangles below D and above P, start subscript, e, end subscript (consumer surplus) and below P, e and above S (producer surplus.
In the market above, consumer surplus can be determined by calculating the area of the green triangle:
CS=12×[(95)×4000]=12×16,000=$8,000\begin{aligned}CS &= \dfrac{1}{2} \times [(9-5) \times 4000]\\\\ &= \dfrac{1}{2} \times 16,000\\\\ &= \$8,000\end{aligned}
Producer surplus can be determined by calculating the area of the red triangle.
PS=12×[(51)×4000]=12×16,000=$8,000\begin{aligned}PS&= \dfrac{1}{2} \times [(5-1) \times 4000]\\\\ &= \dfrac{1}{2} \times 16{,}000\\\\ &= \$8{,}000\end{aligned}
Total welfare (total surplus) can be calculated by adding the sum of consumer surplus and producer surplus:
T, W, equals, dollar sign, 8, comma, 000, plus, dollar sign, 8, comma, 000, equals, dollar sign, 16, comma, 000
When a market is allocatively inefficient, the deadweight loss can be calculated.
The market above is inefficient because at the quantity of 2, comma, 000 oranges M, B, is greater than, M, C. The welfare loss from the underproduction of oranges is represented by the purple and orange triangles, which can be calculated:
DWL=12×[(73)×(40002000)]=12×(4×2000)=$4,000\begin{aligned}DWL&= \dfrac{1}{2} \times [(7-3) \times (4000-2000)]\\\\ &= \dfrac{1}{2} \times (4 \times 2000)\\\\ & = \$4{,}000\end{aligned}
The loss of consumer and producer surplus from this market underproducing oranges equals dollar sign, 4, comma, 000.

Common errors and useful hints

  • The term surplus in the context of consumer, producer or community surplus should not be confused with the term surplus learned in earlier units. When the quantity supplied in a market exceeds the quantity demanded, we say there is a surplus in the market. This excess supply is undesirable and represents an overproduction of a good. Community surplus, on the other, is desirable and will be maximized when a market is achieving allocative efficiency.
  • Calculating areas of consumer and producer surplus or deadweight loss requires the ability to calculate the areas of both a triangle and a rectangle. Keep this equation in mind. For a triangle start text, A, r, e, a, end text, equals, start fraction, 1, divided by, 2, end fraction, left parenthesis, start text, b, a, s, e, end text, times, start text, h, e, i, g, h, t, end text, right parenthesis, and for a rectangle start text, A, r, e, a, end text, equals, start text, b, a, s, e, end text, times, start text, h, e, i, g, h, t, end text

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