This article will explain consumer and producer surplus are and will also discuss the impact of increases in consumer and producer surplus. Furthermore, the article will investigate how the price elasticity of demand can affect the incidence of such surpluses.
Welcome to Simply Economics. This article is the twelfth in a series to explain economics to those who want to broaden their scope of the subject. Click here to find out more about the series. This article explains the determinants of price elasticity of supply.
WHAT IS CONSUMER SURPLUS
Consumer surplus is the extra amount of money that consumers are willing to pay for a good above the equilibrium price, it is the satisfaction gained from a product after accounting for its price.
WHAT IS PRODUCER SURPLUS
Producer surplus is the extra amount of money producers are paid to supply a product above what they are willing to supply the product for.
Below is a graph which shows the area of producer and consumer surplus.
In Figure 1, the areas of consumer and producer surplus are shown on a simple supply and demand diagram.
Pe is the equilibrium price and Qe is the equilibrium quantity of the supply and demand of the good (i.e. when supply is equal to demand).
From Figure 1 the following formula can be derived for consumer and producer surplus:
CONSUMER SURPLUS = (Qe x (P2 – Pe)) ÷ 2.
PRODUCER SURPLUS = (Qe x (Pe – P1)) ÷ 2.
- Qe is the equilibrium price.
- Pe is the equilibrium price.
- P2 is the y-intercept of the demand curve.
- P1 is the y-intercept of the supply curve.
WHERE DO THE EQUATIONS COME FROM?
As shown by Figure 1, the areas of consumer and producer surplus are right-angled triangles. The area of a right-angled triangle is (base x height) ÷ 2.
Therefore, for consumer surplus if the base is Qe and the height to be the difference between P2 and Pe then the formula to find consumer surplus would be:
Similarly, for producer surplus if the base is taken to be Qe and the height to be the difference between Pe and P1 then to formula to find producer surplus would be:
EFFECTS OF A CHANGE IN DEMAND AND SUPPLY
An outward shift in the demand curve will cause and increase in both consumer and producer surplus. However, this assumes all other factors including the supply of the good remains the same.
Similarly, if there is an outward shift in the supply curve of a good then it will cause an increase in the consumer and producer surplus.
On the other hand, if there is an inward shift in the demand or supply curves then it will cause the consumer and producer surpluses to be reduced. In order to develop your understanding, it is good practise to draw out these changes.
THE INCIDENCE OF CONSUMER AND PRODUCER SURPLUS
In theory, if the price elasticity of demand is equal to -1 and the price elasticity of supply is equal to 1, the consumer surplus and producer surplus would be the same. However, it is likely that the price elasticity of demand and price elasticity of supply will not equal -1 and 1, respectively.
This is important to understand because a change in the PED and PES influences the size of the producer and consumer surplus as shown below in Figure 3.
As shown by Figure 3, if a good or service has inelastic demand and elastic supply then most of the surplus will fall on the consumer. This is beneficial for the consumer because although they are willing to pay a lot more for the good (P2), they pay much less for the good (Pe), therefore the welfare gain for the consumer high.
As shown by Figure 4, if a good or service has elastic demand and inelastic supply then most of the surplus will fall on the producer. This is beneficial for the producer because although they are willing to supply good for a lot less (P1), they sell it for much more (Pe), therefore the welfare gain for the producer is high.
Overall, consumer and producer surplus shows the welfare gained by the consumer and producers. However, the amount of welfare gained from selling/purchasing a good can vary due to the PED and PES of the good.