Consumer and Producer
Surplus
Consumer Surplus
• Consumer Surplus is the difference between the price that consumers
pay and the price that they are willing to pay.
• On a supply and demand curve, it is the area between the equilibrium
price and the demand curve
• For example,
• if you would pay 76p for a cup of tea, but can buy it for 50p – your
consumer surplus is 26p
• Diagram of Consumer Surplus
Consumer surplus and economic
welfare
• Consumer surplus is a measure of the welfare that people gain from
consuming goods and services
Producer Surplus
• This is the difference between the price a firm receives and the price
it would be willing to sell it at.
• Therefore it is the difference between the supply curve and the
market price.
Consumer Surplus and Marginal
Utility
• The demand curve is derived from our marginal utility.
• If the marginal utility of a good is greater than the price,
then that is our consumer surplus.
How elasticity of demand affects
consumer surplus
• If demand is price inelastic,
• then there is a bigger gap between the price consumers are willing to pay
and the price they actually pay.
Can firms reduce consumer
surplus?
• Firms can reduce consumer surplus if they have market power. – This enables
them to raise prices above the competitive equilibrium.
• In a monopoly, a firm will maximise profits by reducing consumer surplus.
• Another way to reduce consumer surplus is to engage in price discrimination.
– Charging different prices to different groups of consumers.
• Those with inelastic demand will see their consumer surplus reduced.
• To eliminate consumer surplus a firm would need to engage in first-degree
price discrimination – this means charging the consumer the highest price
they are willing to pay.
• To gain market power, a firm could advertise to create brand loyalty, this will
make demand more inelastic
How free trade affects consumer and producer surplus
• Free trade means a reduction in tariffs.
• It leads to lower prices for consumers and an increase in consumer surplus
• If tariffs are cut, then we can import at S Eu (P1) – a lower price than P2.
• Imports increase from (Q3-Q2) to (Q4-Q1)
• However, domestic producers see a decline in producer surplus.
• WIth tariffs, we used to buy Q2 from domestic producers. But, now we only
buy Q1 at price P1.
• So area 1 represents the decline in producer surplus.
What is the significance of
consumer surplus?
• In competitive markets, firms have to keep prices relatively low, enabling
consumers to gain consumer surplus.
• If markets were not competitive, the consumer surplus would be less and
there would be greater inequality.
• A lower consumer surplus leads to higher producer surplus and greater
inequality.
• Consumer surplus enables consumers to purchase a wider choice of goods.
• As Guide to Public Policy:
• The concept has a great practical importance to the finance minister
in determining the desirability of imposing a tax on a certain
commodity. A tax imposed on a commodity tends to raise its price
and thus reduce consumer’s surplus, but it yields some revenue to the
government.
• The finance minister is to compare the loss of consumer’s surplus to the
increase in tax- revenue.
• A tax is justified when the loss in consumer’s surplus is less than the
increase in tax-revenue; otherwise it will be harmful and will lead to loss of
social welfare.
• Similarly, the concept is useful to provide a case for government
subsidies or bounties in some cases, where it can be shown that the
additional net satisfaction possible through subsidies upon consumers
will exceed the loss of satisfaction represented by the money cost
involved. It shows that the concept of consumer’s surplus has a
considerable importance as a guide to public policy.