Consumer and Producer Surpluses

Welfare economics studies the relationship between allocation of resources and well-being of the economy. An equilibrium price is best because it maximizes profits for both buyers and sellers. Consumer surplus concerns the benefits buyers receive from the market.

Buyers' willingness to pay (WTP) is the maximum amount a person is willing to pay. Consumer surplus is the positive difference between a buyer's WTP and the price he pays for the good. A demand curve can be used to demonstrate buyers' willingness to pay, with demand on the x axis and price on the y axis. The area under the demand curve and above the price is the total consumer surplus because consumer surplus = price the buyer(s) willing to pay - price the buyer(s) actually pay(s).

Each seller wants to accept the job if the price buyer offers if higher than the seller's cost, which certainly includes opportunity costs and costs the seller subjectively values. Costs measure the seller's willingness to sell. When the buyer take bids from sellers, the price often starts off high then drops as sellers compete for the job. When the price is lower than the cost, the seller exit the market. When the price is higher than the cost, the difference between the price the seller willing to accept and the price the seller is actually paid the producer surplus.

The supply curve is closely related to producer surplus as the demand curve is to consumer surplus. In the graph of supply curve, we see steps similar to those of the demand curve. Here the height of the step is the cost of the marginal seller, the seller who will leave the market when the price is lower. For example, in the graph, when the price drops from $2 to $1, one seller leaves the market.

Also, the area under the actual price and above the supply curves of bars or steps is total producer surplus because producer surplus = actual price the seller is paid - price the seller is willing to be paid (costs). When the price is raised, total producer surplus increases. The triangle under the original price and above the supply curve expands to a larger similar triangle under the new price and above the supply curve.

Accordingly, consumer surplus and producer surplus are closely related in that they both measure the difference between WTP and the actual price. Their concepts and graphs must be studied carefully because surplus is important for economic welfare. When everyone's profit is maximized, everyone will be happy for participating in the economy and market.

Citation: Economics, McConnell-Brue's.