Consumer and producer surplus

CONSUMER SURPLUS

The maximum price that a customer is willing to pay for a good determines the buyer’s willingness to pay. There are three possible cases when we compare a customer’s willingness to pay and the price on the market:

• If the price of the good on the market is exactly equal to his willingness to pay, the consumer is said to be indifferent on whether to buy or not the good.

• If the price is higher than the customer’s willingness to pay then no trade will happen.

• If the price of the good is lower than the customer’s willingness to pay than there is some consumer surplus.

The consumer surplus is defined as the difference between the customer’s maximum price he is willing to pay and the actual price he pays. It is a measure of the benefits a buyer receives when buying a good and thus is a measure of economic well-being. Obviously the lower the price the higher is the surplus. By summing the surpluses of all customers in the market you obtain the total surplus for the demand side. Consider the market for pizza slices with a small number of buyers (for example 5). The height of the demand curve shows the willingness to pay of each customer. In such a small market, the demand curve does not have the linear shape we are used to, but it is stair shaped. When the price is above 5$ no one in the market is willing to buy a slice of pizza. As the price decreases more buyers will be willing to buy the good. At a price of 2$ for example the first three customers are willing to buy a slice of pizza. We can measure the surplus in the market on the graph as the area below the demand curve and above the horizontal line representing the price.

As the number of consumers in the market grows on the graph there will be represented more “steps” until we can approximate the demand curve with a smooth line as we are used to do. When the price of a good decreases surplus increases because of two effects:

• the customers who are already buying the good will continue to buy it at a lower price

• some customers who were not buying the good initially will now buy it because of the lower price

PRODUCER SURPLUS

The minimum price at which a seller is willing to sell it’s goods determines the producer’s cost. There are three possible cases when we compare a seller’s cost and the price on the market:

• if the price of the good on the market is exactly equal to the cost, the producer is indifferent on whether to produce and therefore sell his goods.

• If the price of the good is lower than the producer’s cost, it is not convenient for the seller to produce and sell its products and therefore no trade happens.

• If the price of the good is higher than the producer’s cost, there is some producer surplus.

The producer surplus is defined as the difference between the price at which goods are sold on the market and the producer’s cost. It is a measure the benefits that a seller receives when selling a good and thus, like the producer surplus, it is a measure of the economic well-being. Obviously, the higher is the price the higher is the surplus. By summing all the surpluses all customers in the market you obtain the total surplus for the supply side. Consider the market for slices of pizza once again but this time let’s have a small number of sellers (for example 5). The height of the supply curve shows the cost for each seller. In such a small market, the supply curve does not have the linear shape we are used to, but it is stair shaped. When the price on the market is below 1.5 no seller is willing to operate in the market. As the price increases more sellers are willing to sell their products. At a price of $3 for example the first two producers are willing to sell their slices of pizza. We can measure producer surplus on the graph as the area between the horizontal line representing price and the supply curve.

As the number of producers in the market increases on the graph there will be represented more “steps” until we can approximate the supply curve with a smooth line as we are used to do. When the price of a good increases, surplus increases as well because of two effects:

• Sellers who were selling their products on the market yet will continue at a higher price

• Some sellers who were not selling the good initially now start doing so because of the higher price.

MARKET EFFICIENCY

If we want to measure the economic well being of a society, one way to do so is by considering the total surplus which is the sum of producer surplus in the market. It is computed as:

(maximum price customers are willing to pay – price) + (price – cost for sellers) = maximum price customers are willing to pay – cost for sellers.

Total surplus can graphically be identified as the are between the demand and the supply curve. We have a situation of efficiency when total surplus in the market is maximized. Markets which are free and competitive achieve efficiency because the give the possibility to everybody who is willing to buy or sell a good at the market price the possibility to do so. It’s important to stress that efficiency is not the only objective governments aim to achieve: equality, which is defined as the distribution of resources in an equal way across people, is often an objective governments tend to achieve in order to improve society. Governments can do so with the help of the so called governments policies which we have analysed in the lecture about price ceilings and price floors.