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Chapter 7: Market Efficiency and Welfare1
7.1 Consumer Surplus and Producer Surplus
Using the tools of consumer and producer surplus, we can demonstrate the efficiency of a competitive market--that the equilibrium price and quantity in a competitive market maximize the welfare of consumers and producers. We can also use those tools to study the welfare effects of government policy, such as taxes and price controls.
By calculating the changes in consumer and producer surplus that result from government intervention, we can measure the impact on buyers and sellers.
What a consumer is required to pay for a good is usually less than what she is willing to pay. The monetary difference between what the consumer is willing to pay and what the consumer actually pays--the market price--is called consumer surplus.
Consumer surplus is shown graphically as the area under the demand curve (willingness to pay for the units consumed) and above the market price (what must be paid for those units).
Exhibit 1: Julie’s Consumer Surplus for Iced Tea
Exhibit 2: Consumer Surplus
If the consumer is a buyer of several units of a good, the earlier units will have greater marginal value and therefore create more consumer surplus, because marginal willingness to pay falls as greater quantities are consumed in any period.
An increase in supply will lower the price and increase your consumer surplus for each of the units you were already consuming, and will also increase consumer surplus from increased purchases at the lower price. Conversely, an increase in price will lower the amount of consumer surplus.
Exhibit 3: Impact of an Increase in Supply on Consumer Surplus
Producer surplus is the difference between what a producer is paid for a good and the seller=s cost for producing each unit of the good.
Because some units can be produced at a cost that is lower than the market price, the seller receives a surplus, or net benefit, from producing those units.
Producer surplus for a particular unit is the difference between the market price and the seller=s cost of producing that unit. Total producer surplus is shown graphically as the area under the market price (what was paid for those units) and above the supply curve (the total cost, or sum of marginal costs, of producing those units).
Exhibit 4: A Firm’s Producer Surplus
Exhibit 5: Market Producer Surplus
A higher market price due to an increase in demand will increase total producer surplus. Part of the added surplus is due to a higher price for the quantity already being produced, and part is due to the expansion of output made profitable by the higher price.
Exhibit 6: Impact of an Increase in Demand on Producer Surplus
With the tools of consumer and producer surplus, we can better analyze the total gains from exchange. The demand curve represents a collection of maximum prices that consumers are willing and able to pay for additional quantities of a good or service, while the supply curve represents a collection of minimum prices that suppliers require to be willing to supply additional quantities of that good or service.
At the market equilibrium, consumers receive consumer surplus and producers receive producer surplus. Both benefit from trading every unit up to the market equilibrium output. Buyers purchase each good, except for the very last unit, for less than the maximum amount that they would have been willing to pay; sellers receive more than the minimum amount they would have been willing to accept to supply the good.
Once the equilibrium output is reached at the equilibrium price, all of the mutually beneficial trade opportunities between the suppliers and the demanders will have taken place, and the sum of consumer and producer surplus is maximized.
The total welfare gain to the economy from trade in a good is the sum of the consumer and producer surplus created. Consumers benefit from additional amounts of consumer surplus and producers benefit from additional amounts of producer surplus.
Improvements in welfare come from additions to both consumer and producer surplus. In competitive markets, where there are large numbers of buyers and sellers, at the market equilibrium price and quantity, the net gains to society are as large as possible.
In the News: Is Santa a Deadweight Loss?
Exhibit 7: Consumer and Producer Surplus
Not producing the efficient level of output leads to a deadweight loss of reduced consumer and producer surplus.
Great Economic Thinkers: Alfred Marshall
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