Economic surplus

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This page deals with the various forms of economic surplus, including producer, consumer, government, and social/total surplus. For information about a budget surplus, see budget deficit.

Graph illustrating consumer (red) and producer (blue) surpluses on a supply and demand chart

The term surplus is used in economics for several related quantities. The consumer surplus (sometimes named consumer's surplus or consumers' surplus) is the amount that consumers benefit by being able to purchase a product for a price that is less than they would be willing to pay. The producer surplus is the amount that producers benefit by selling at a market price that is higher than they would be willing to sell for. Note that producer surplus flows through to the owners of the factors of production, unlike economic profit which is zero under perfect competition. If the markets for factors are perfectly competitive as well, producer surplus ultimately ends up as economic rent to the owners of scarce inputs such as land.

1 Overview
2 Consumer Surplus
3 See also
4 Further reading
- 4.1 List of Marketing Topics

[edit] Overview

On a standard supply and demand (S&D) diagram, consumer surplus (CS) is the triangular area above the price and below the demand curve, since intramarginal consumers are paying less for the item than the maximum that they would pay. In contrary, producer surplus (PS) is the triangular area below the price and above the supply curve, since that is the minimum quantity a producer can produce.

If the government intervenes by implementing, for example, a tax or a subsidy, then the graph of supply and demand becomes more complicated and will also include an area that represents government surplus.

Combined, the consumer surplus, the producer surplus, and the government surplus (if present) make up the social surplus or the total surplus. Total surplus is the primary measure used in welfare economics to evaluate the efficiency of a proposed policy.

A basic technique of bargaining for both parties is to pretend that their surplus is less than it really is: sellers may argue that the price they ask hardly leaves them any profit, while customers may play down how eager they are to have the article.

In national accounts, operating surplus is roughly equal to distributed and undistributed pre-tax profit income, net of depreciation.

In heterodox economics, the economic surplus denotes the total income which the ruling class derives from its ownership of scarce factors of production, which is either reinvested or spent on consumption.

In Marxian economics, the term surplus may also refer to surplus value and surplus labour.

[edit] Consumer Surplus

Consumer surplus is the difference between the price consumers are willing to pay (or reservation price) and the actual price. If someone is willing to pay more than the actual price, their benefit in a transaction is how much they saved when they didn't pay that price. For example, a person is willing to pay a tremendous amount for water since he needs it to survive, however since there are competing suppliers of water he is able to purchase it for less than he is willing to pay. The difference between the two prices is the consumer surplus.

[edit] Calculation from supply and demand

The aggregate consumers' surplus is the sum of the consumer's surplus for each individual consumer. This can be represented on a supply and demand figure. The consumer surplus is the area under the demand curve and above a horizontal line at the equilibrium price. If the demand curve is a straight line, the consumer surplus is the area of a triangle:

$CS = \frac{1}{2} Q_{mkt} \left( {P_{max} - P_{mkt}} \right)$

Where P_mkt is the equilibrium price (where supply equals demand), Q_mkt is the total quantity purchased at the equilibrium price and P_max is the price at which the quantity purchased would fall to 0 (that is, where the demand curve intercepts the price axis). For more general demand and supply functions, these areas are not triangles but can still be found using Integral Calculus. Consumer surplus is thus the definite integral of the demand function with respect to price, from the market price to the maximum reservation price (i.e. the price-intercept of the demand function):

$CS = \int_{P_{mkt}}^{P_{max}} D(P)\, dP,$ where $D(P_{max}) = 0.\,$

The graph shows, that if we see a rise in the equilibrium price and a fall in the equilibrium quantity, then consumer surplus falls.

[edit] Distribution of benefits when price falls

When supply of a good expands, the price falls (assuming the demand curve is downward sloping) and consumer surplus increases. This benefits two groups of people. Consumers who were already willing to buy at the initial price benefit from a price reduction, and additional consumers who were unwilling to buy at the initial price but will buy at the new price and also receive some consumer surplus.

Consider an example of linear supply and demand curves. For an initial supply curve S₀, consumer surplus is the triangle above the line formed by price P₀ to the demand line (bounded on the left by the price axis and on the top by the demand line). If supply expands from S₀ to S₁, the consumers' surplus expands to the triangle above P₁ and below the demand line (still bounded by the price axis). The change in consumer's surplus is difference in area between the two triangles, and that is the consumer welfare associated with expansion of supply.

Some people were willing to pay the higher price P₀. When the price is reduced, their benefit is the area in the rectangle formed on the top by P₀, on the bottom by P₁, on the left by the price axis and on the right by line extending vertically upwards from Q₀.

The second set of beneficiaries are new consumers, those who will pay the new lower price (P₁) but not the higher price (P₀). Their additional consumption makes up the difference between Q₁ and Q₀. Their consumer surplus is the triangle formed by on the left by the line extending vertically upwards from Q₀, on the right by the demand line, and on the bottom by the line extending horizontally to the right from P₁.

[edit] Rule of one-half

The rule of one-half estimates the change in surplus for small changes in supply with a constant demand curve. Following the figure above,

$\Delta CS = \frac{1}{2} \left( {Q_1 + Q_0 } \right)\left( {P_0 - P_1 } \right)$

where:

CS = Consumers' Surplus
Q₀ and Q₁ are the quantity demanded before and after a change in supply
P₀ and P₁ are the prices before and after a change in supply

[edit] See also

[edit] Further reading

Henry George, Progress and Poverty [1]

v • d • e Topics in microeconomics

Scarcity • Opportunity cost • Supply and demand • Elasticity • Economic surplus • Economic shortage • Aggregation problem • Consumer theory • Production, costs, and pricing • Market form • Welfare economics • Market failure