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Consumer Surplus and Producer Surplus

Economic terms used to determine market wellness by studying the relationship between the consumers and suppliers

What are Consumer Surplus and Producer Surplus?

Both consumer surplus and producer surplus are economic terms used to define market wellness by studying the relationship between the consumers and suppliers. They explain the opportunity cost consumers forego to gain a marginal benefit for buying a good or service. To the producer, it is the willingness and ability to produce an extra unit of a product based on the marginal cost of producing more goods.

 

Consumer Surplus and Producer Surplus

 

Summary

  • Both consumer surplus and producer surplus are economic terms used to define market wellness by studying the relationship between the consumers and suppliers.
  • The consumer surplus refers to the difference between what a consumer is willing to pay and what they paid for a product.
  • The producer surplus is the difference between the market price and the lowest price a producer is willing to accept to produce a good.

 

Understanding Consumer Surplus and Producer Surplus

When discussing consumer and producer surplus, it is important to understand some base concepts used by economists to explain the inter-relationship.

Both consumer and producer surplus can be graphed to display either a demand curve or marginal benefit curve (MB) and a supply curve or marginal cost curve (MC).

 

Consumer Surplus and Producer Surplus

 

Consumer surplus refers to the monetary gain enjoyed when a purchaser buys a product for less than what they normally would be willing to pay. Each corresponding product unit price along the supply curve is known as the marginal cost (MC).

 

Supply Curve

 

On the other hand, the producer surplus is the price difference between the lowest cost to supply the market versus the actual price consumers are willing to pay. The price of a product unit along the supply curve is known as the marginal cost (MC).

When graphing consumer surplus, the area above every extra unit of consumption, is referred to as the total consumer surplus. Similarly, the area above the supply curve for every extra unit brought to the market is referred to as the total producer surplus.

When you add both the consumer and producer surplus, you get the total surplus, also known as total welfare or community surplus. It is used to determine the well-being of the market. When all factors are constant, in a perfect market state, an equilibrium is achieved. This state is also referred to as allocative efficiency – the marginal cost and marginal benefit are equal.

 

Allocative Efficiency

 

Understanding Consumer Surplus

To fully conceptualize consumer surplus, take an example of a demand curve of chocolates plotted on a graph. The unit price is plotted on the Y-axis and the actual chocolate units of demand per day on the X units. The graph below shows the consumer surplus when consumers purchase two units of chocolates.

 

Consumer Surplus

 

Calculating the Total Consumer Surplus

 

Total Consumer Surplus - Calculation

 

To calculate consumer surplus, account for Δ0 units. In the graph above, the corresponding unit price is $14. It is the market price that consumers are able and willing to purchase a bar of chocolate.

Since the demand curve is linear, the shape formed between Δ0 unit to 2 and below the demand curve is triangular. Therefore, the ordinary formula for finding an area of a triangle is used. The unit items cancel out to leave the result expressed in monetary form.

 

Total Consumer Surplus Formula

 

Total Consumer Surplus - Formula

 

Where:

  • Qn = Quantity of demand/supply either at equilibrium or the willing purchasing or selling price
  • ΔP = The difference between the price at equilibrium or at the purchasing or selling point and the price at Δ0

 

Calculating the Total Consumer Surplus

 

Sample Calculation

 

In summation, the market saves $3 for the same unit it could’ve purchased for $14.

 

Understanding Producer Surplus

Using the same example with all the X and Y-axis numbers, the producer surplus is calculated using the same formula. Below is the graph for the illustration:

 

Producer Surplus

 

Calculating the Total Producer Surplus

 

Total Producer Surplus - Sample Calculation

 

The producer surplus cost at two units is $4 ($6 – $2). This means that the supplier(s) will forego $4 per unit for producing two units.

 

Total Surplus

In the previous example, the total consumer surplus was $3, and the total producer surplus $4, respectively. The total surplus, therefore, will be $7 ($3 + $4). Below is the formula:

 

Total Surplus = Consumer Surplus + Producer Surplus

 

Total Surplus

 

In the above example, the total surplus does not depict the equilibrium. There is a deadweight to shed off. Supplier overheads are higher for producing two units. Similarly, the consumer is getting less than what the market can offer.

As a result, to achieve a stable market, the producer(s) must increase the production to reduce the deadweight and attain the equilibrium. At the equilibrium, the consumer(s) will enjoy the highest marginal utility, and supplier(s) will maximize profits.

 

Related Readings

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In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

  • Demand
  • Marginal Benefit
  • Deadweight Loss
  • Marginal Utility

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