Consumer and Producer Surplus
measures of Welfare
Definition of Consumer Surplus:
'The difference between the maximum price the consumers are willing to pay for a good/service and the current market price.'
Definition of Producer Surplus:
'The difference between the minimum price the producers can sell a good/service for and the current market price.'
Why do we need to know about consumer and producer surplus?
Remember that much of economics tries to maximise the welfare of society, given a set of finite resources.
Both consumer and producer surplus are measures of welfare. Therefore if consumer surplus goes up, then the consumers' welfare will go up. This is why consumer and producer surplus is an important topic in microeconomics.
Another thing you should be aware of is that price generates a transfer of welfare between consumer and producer.
For example: When the price of a good or service increases, welfare is taken away from the consumer. That welfare is transferred to the producer. The opposite is true for the alternate case. When prices decrease, welfare is transferred from the producer to the consumer.
The diagram above shows how consumer surplus changes due to a change in the market price. In the diagram, the original market price is P1, with a quantity of Q1. The consumer surplus is the difference between the market price and the maximum possible price, Pmax.
Therefore, the total consumer surplus is shown by the two areas, A and B.
There is a change in the market place, which disrupts the market equilibrium and increases the market price to P2, with quantity Q2. This has an adverse effect on consumer surplus. Prices have increased, so consumers are surely worse off than before: therefore, consumer surplus decreases. The remaining consumer surplus is Area A. The consumer surplus that has been lost is Area B.
Why does consumer surplus decrease when the price goes up?
1) Consumers face a higher opportunity cost when buying a good/service when its price increases. Therefore, many consumers will end up leaving the market and not make a purchase. That's why in the above diagram the quantity drops from Q1 to Q2.
2) Some consumers will remain in the market and therefore they will gain welfare from the good that they are buying, however at a higher price than before. So they have to give up more to get welfare from the product.
These two reasons explain why consumer surplus has decrease in the market and explain why consumers in society are worse off.
What about producer's welfare?
The diagram above shows the effect of price on producer surplus. The original price in the market is P1. Producer surplus is defined as the difference between the minimum possible price and the market price. The area above the supply curve from Pminup until P1 is therefore the producer surplus. This yields a producer surplus of Area A.
Next, there is a change in the market, which causes the price to increase from P1 to P2. This increases the difference between market price and minimum price. It means that producers are better off, which makes sense because producers do enjoy price increases!
The producer surplus has increased because the new price is P2, and price minimum is the same. The producers gain welfare of area B. Therefore, the new total producer surplus is Area A + B.
Let's now show consumer and producer surplus on the same diagram. Consumer surplus is shown by the area under the demand curve between price maximum and market price. This is therefore, Area A.
Producer surplus is shown by the area above the supply curve, between price minimum and market price. This is therefore, Area B
If the price were to increase, this would be worse for consumers and better for producers. So there would be a decrease in consumer surplus and an increase in producer surplus. As mentioned above, this is called a transfer of welfare.
What have we learned?
Consumer and producer surplus definitions.
Diagrammatic application of consumer and producer surplus.
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