Consumer Surplus, Producer Surplus, and the efficiency

of competitive markets

Peng Shen

September 29, 2021

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Motivation

Market equilibrium is a result of consumers’ and firms’ self-interest

choices.
Is the market equilibrium good for the society? Is there other point where
both consumers and firms can benefit more from the trade?

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Motivation

Adam Smith, The Wealth of Nations:

he intends only his own gain, and he is in this, as in many other cases, led
by an invisible hand to promote an end which was no part of his
intention. Nor is it always the worse for the society that it was not part of
it. By pursuing his own interest he frequently promotes that of the society
more effectually than when he really intends to promote it.

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Motivation

Today’s goal:
Evaluate consumers’ and firms’ benefit from participating in the
market
Under what condition can market equilibrium attain the economic
efficiency?

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Demand Curve as Marginal Benefit Curve

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Demand Curve as Marginal Benefit Curve

Marginal benefit: the additional

benefit to a consumer from
consuming one more unit of a good
or service.

Consumers are willing to purchase a

product up to the point where the
marginal benefit of consuming a
product is equal to its price.

Buyer’s reservation price: is the

highest price an individual is willing
to pay for a good

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Consumer Surplus

Consumer surplus (CS): the difference between the buyer’s reservation

price of a good or service and the actual price the consumer pays.
CS measures the net dollar benefit consumers receive from buying goods
or services in a particular market.

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Consumer Surplus

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CS in a market with many buyers

If there are infinitely many buyers (and we can record each one’s
reservation price), then we have the market demand curve and CS in the
market as below

Figure 1: CS in the market for chai tea when the price is $2.00

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Interpretation of Demand Curve

Horizontal Interpretation: Given price, how much will buyers buy?

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Interpretation of Demand Curve

Horizontal Interpretation: Given price, how much will buyers buy?

E.g., At a price of $2.00, the quantity demanded is 15,000 cups of tea per
day.

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Interpretation of Demand Curve

Horizontal Interpretation: Given price, how much will buyers buy?

E.g., At a price of $2.00, the quantity demanded is 15,000 cups of tea per
day.
Vertical Interpretation: Given the quantity to be sold, what price is the
marginal consumer willing to pay?

Peng Shen Consumer & Producer Surplus, Efficiency September 29, 2021 9 / 21
Interpretation of Demand Curve

Horizontal Interpretation: Given price, how much will buyers buy?

E.g., At a price of $2.00, the quantity demanded is 15,000 cups of tea per
day.
Vertical Interpretation: Given the quantity to be sold, what price is the
marginal consumer willing to pay?
E.g., The marginal consumer is willing to pay $2.00 per cup for the
15,000th cup of tea sold in the market.

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Review: area of rectangle and triangle

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Review: area of rectangle and triangle

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Supply Curve as Marginal Cost Curve

Lowest Price
Heavenly Tea
willing to accept
1st cup 1.25
2nd cup 1.50
3rd cup 1.75
4th cup 2.00

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Producer surplus

Marginal (opportunity) cost: the additional opportunity cost to a firm

when producing one more unit of a good or service.
The lowest price Heavenly Tea is willing to accept to supply a cup of tea is
equal to its marginal cost of producing that cup of tea.
Seller’s reservation price is the lowest price the seller would be willing to
sell for.

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Producer surplus

Marginal (opportunity) cost: the additional opportunity cost to a firm

when producing one more unit of a good or service.
The lowest price Heavenly Tea is willing to accept to supply a cup of tea is
equal to its marginal cost of producing that cup of tea.
Seller’s reservation price is the lowest price the seller would be willing to
sell for.
Producer surplus (PS): the difference between the seller’s reservation price
of a good or service and the price it actually receives.
Producer surplus measures the net dollar profit firms receive from selling
goods or services in a particular market.

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Producer Surplus

Similar to demand and consumer surplus, we can also derive the market
supply and producer surplus from several sellers to infinitely many sellers.

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Interpretation of Supply Curve

Horizontal Interpretation: Given price, how much will suppliers offer?

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Interpretation of Supply Curve

Horizontal Interpretation: Given price, how much will suppliers offer?

E.g., At a price of $2.00, the suppliers are willing to sell 15,000 cups of tea
per day.

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Interpretation of Supply Curve

Horizontal Interpretation: Given price, how much will suppliers offer?

E.g., At a price of $2.00, the suppliers are willing to sell 15,000 cups of tea
per day.
Vertical Interpretation: Given the quantity to be sold, what is the
opportunity cost of the marginal seller?

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Interpretation of Supply Curve

Horizontal Interpretation: Given price, how much will suppliers offer?

E.g., At a price of $2.00, the suppliers are willing to sell 15,000 cups of tea
per day.
Vertical Interpretation: Given the quantity to be sold, what is the
opportunity cost of the marginal seller?
E.g., The marginal (opportunity) cost of producing the 15,000th cup of
tea is $2.00.

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Economic Surplus

Economic surplus: the sum of consumer surplus and producer surplus.

Economic surplus is a natural measure we have to calculate the benefit to
society from the production of a particular good or service.
When is economic surplus maximized?

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Perfectly Competitive Market Equilibrium

Equilibrium in a perfectly competitive market results in the greatest

amount of economic surplus, or total net benefit to society, from the
production of a good or service.

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Deadweight Loss

A deadweight loss is the decrease in total surplus that results from

inefficient underproduction or overproduction
Economic Deadweight
surplus loss
At competitive A+B
None
equilibrium +C+D+E
At a price at most
C+E
of $2.20 A+B+D

In a perfectly competitive market equilibrium, we have economic efficiency,

a situation in which no one can improve without hurting others.

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MB=MC
Recall that we can regard the demand (resp. supply) curve as the marginal
benefit (resp. cost) curve.
Generally, MB is decreasing and MC is increasing.
Equilibrium in a competitive market results in the economically efficient
level of output, at which MB=MC.

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MB=MC

Situations when there are Excess Supply–surplus of products, and Excess

Demand–shortage of products.

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MB=MC

Situations when there are Excess Supply–surplus of products, and Excess

Demand–shortage of products.

When there is excess supply (MB < MC )

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MB=MC

Situations when there are Excess Supply–surplus of products, and Excess

Demand–shortage of products.

When there is excess supply (MB < MC )

When there is excess demand (MB > MC )

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Equilibrium, Efficiency, and Optimality

Equilibrium Principle: a market in equilibrium leaves no unexploited

opportunities for individuals. But it may not be optimal.
Producers sometimes shift costs to others, and buyers may create
benefits for others

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Equilibrium, Efficiency, and Optimality

Equilibrium Principle: a market in equilibrium leaves no unexploited

opportunities for individuals. But it may not be optimal.
Producers sometimes shift costs to others, and buyers may create
benefits for others

1 Production is efficient when total surplus is maximized.

Total surplus is maximized when MB = MC .
2 The socially optimal quantity maximizes total surplus, provided the
supply and demand curves reflect all costs and benefits associated
with the production and consumption of the product.
Economic efficiency: all goods are produced at their socially optimal
level, no one can better off without hurting others.

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