Consumer and Producer Surplus

Imagine you are ready to buy the new Apple AirPods Max for £800, and when you go to the store, you end up paying £550. What benefit did you get from actually paying less than £800? How much did the seller benefit from being willing to sell the new AirPods Max for less than £250? That’s what consumer and producer surplus is all about. In this article, you’ll learn everything you need to know about consumer and producer surplus.

Consumer and producer surplus definition

What is the difference between consumer surplus and producer surplus?

Consumer surplus refers to the difference between the price a consumer is willing to pay for a particular good and the price they pay. Consumer surplus is an excellent way to measure how much an individual benefits from a transaction in an economy.

Consumer surplus is an important metric for measuring consumer wealth in society. In general, an increase in consumer welfare follows an increase in consumer surplus. There are many factors that affect consumer wealth. A price increase always leads to a decrease in consumer surplus and thus to a decrease in consumer welfare.

In economics, producer surplus is defined as the difference between the amount a firm producing the goods is willing to pay for a given quantity of goods and the amount it can earn by selling the goods at the market price.

The difference, also called the surplus amount, is the benefit the producer receives from selling the item in the market. A producer surplus occurs when market prices for goods are higher than the lowest price producers would otherwise be willing to accept for their goods.

Producer surplus is an essential factor in measuring the economic welfare of producers. It helps find the optimal allocation of resources that benefit society as a whole.

Producer surplus calculation

We can calculate producer surplus.

Fig. 1 - Producer surplus

Figure 1 shows the producer surplus, which you can find above the supply curve. The area of the triangle P1-A-Pmin is the area of producer surplus.

Considering the P1-A-Pmin triangle, you can calculate the producer surplus.

The formula to calculate the area of a right-angled triangle is:

$\frac{1}{2}\times Base\times Height$

In this case, the base of the triangle is the quantity sold at price P1 = Q1, whereas the height of the triangle is equal to the price that the firm sells their good, subtracting the minimum price the firm would accept to sell the good = P1-Pmin

Therefore we have,

$Producersurplus=\frac{1}{2}\times Q1\times (P1-Pmin)$

Consumer surplus calculation

We can calculate consumer surplus.

Fig. 2 - Consumer surplus

Figure 2 shows the consumer surplus on a graph. Consumer surplus is the difference between the maximum price a consumer is willing to pay and the price they end up paying.

The triangle P1-Pmax-A represents the consumer surplus is represented. Again, you can use the formula that helps calculate the area of a triangle to calculate the consumer surplus.

The formula to calculate the area of the right-angled triangle is:

$\frac{1}{2}\times Base\times Height$

In this case, the triangle’s height is the difference between the maximum price a consumer is willing to pay and the price they end up paying = Pmax-P1. The base equals the total quantity the consumer gets from paying P=Q1.

Therefore, consumer surplus is:

$Consumersurplus=\frac{1}{2}\times Q1\times (Pmax-P1)$

There are many factors that can influence the consumer surplus. Generally, consumer surplus is much higher in a perfectly competitive market, whereas it is lower in an imperfectly competitive market.

Consumer and producer surplus in monopoly

We can analyse the effects that monopoly has on producer and consumer surplus.

Fig. 3 - Consumer and producer surplus in monopoly and perfect competition

Figure 3 shows the impact monopoly has on producer and consumer surplus. It first assumes that the market was initially in perfect competition at point 1, diagram 2. At this point, there is a Q1 amount of goods exchanged for P1. However, when the firm receives market power and turns into a monopoly, it charges higher prices, as seen in diagram 2. When higher prices are charged, not everyone can afford the new price. Therefore, the quantity demanded drops to Q2.

Remember that in a monopoly, the MC curve is equal to what would be the supply curve of the firm if the market was in perfect competition. Assume that to maximise the profit, the firm chooses to price where MC=MR. As shown in the diagram above, this increases the price to P2.

How does this impact the consumer surplus? The total amount that a consumer was willing to pay is at point Pmax. Under perfect competition, a consumer would pay P1, and the total benefit would be Pmax-P1.

On the other hand, in a monopoly, where the price has increased to P2, the consumer surplus has shrunk, as Pmax-P2 is smaller than Pmax-P1. You can see from the figure that the consumer surplus was initially the triangle P1-Pmax-1, and after monopoly, it became P2-Pmax-2.

On the other hand, the producer surplus of monopoly has increased at the expense of the consumer. The minimum amount a firm will choose to exchange for their product can be found where the MC curve intersects the y-axis. That’s because a firm will not supply when the price is below the MC as it would make losses.

In equilibrium, the producer surplus was the difference between the price they are selling their goods for and the minimum price they are willing to accept. When the price was P1, the producer surplus was P1-Pmin-1. After the price had increased, the producer surplus became P2-Pmin-3-2, where P2 is greater than P1. The gain in producer surplus at the expense of consumer surplus is represented by the rectangular area P1-P2-2-4.

However, there is a loss for both consumer and producer surplus in a monopoly. That is due to the drop in quantity from Q1 to Q2. This is known as deadweight loss and represents the economic loss of welfare. In other words, it illustrates how much the society losses from a monopoly, as resource allocation doesn’t occur at optimal levels. The deadweight loss is shown by the triangle 1-2-3 in diagram 1 of Figure 3.

Keep in mind that there will be a loss in overall economic welfare whenever there is an imperfectly competitive market. Additionally, there will be an increase in producer surplus in such a market structure at the expense of consumer surplus.

Price elasticity of demand and consumer surplus

Price elasticity of demand measures how sensitive the quantity demanded is towards a price change. A demand curve is inelastic when the change in quantity demanded is proportionally lower than the price change. A demand curve is elastic when the change in quantity demanded is proportionally greater than the price change.

Therefore, the elasticity of demand will determine the size of the consumer surplus.

Fig. 4 - Consumer surplus and elasticity of demand

Figure 4 shows the consumer surplus when you have price elastic and inelastic demand.

As seen in diagram one, the consumer surplus is higher when the demand is inelastic. That’s because the consumers are willing to pay a higher price for the good. Therefore there is a larger gap between Pmax and Pe.

On the other hand, when the demand is elastic, consumers will be willing to pay a lower price for the good. There is a smaller gap between Pmax and Pe, as seen in diagram 2. This makes the consumer surplus smaller.

To learn more about demand’s price elasticity, check our explanation – Price Elasticity of Demand.