Consumer surplus is defined as the measure of the consumer’s capability to refrain from spending money or purchasing alternate products to acquire a specific product. Consumer surplus also comprises the amount of money that a consumer doesn’t spend to purchase a desired product. For example, a consumer who intends to buy a Mercedes may have to cut expenses for a month to make the purchase. Another person might be willing to buy a highly-priced and superior model for which he limits expenses or looks for a deal. Making a difference from the above-mentioned individuals, a consumer may also spend any amount of money to buy a desired model and care less about the expenses. In this example, consumer surplus is the amount of money exceeding the minimum reasonable price that a consumer is willing to pay for a Mercedes Car (Alguacil et al., 2013).
Figure 1: Consumer and Surplus Graph
Source: (Walzer et al., 2013)
Producer surplus is the excess price charged by a producer or manufacturer for a product. Generally, the excess is derived from products as well as the amount considered by the producer as an apt compensation for the production process. For example, Mercedes sellers generally set high prices for a car (Anandarajah & McGlade, 2012). This price is subject to negotiation and the seller sells the car at the highest possible price paid by the customer. Thus producer surplus can be defined as the margin between the minimum reasonable price of a product and the selling price of the product.
The definitions of consumer and producer surplus can be further explained in relevance to the supply and demand curves. An example from the auto industry and its explanation would clarify the implications of consumer and producer surplus in market analysis.
Figure 1: Demand Curve
Source: (Steinberg, 2013)
The above demand curve can be used to determine the consumer surplus. The consumer surplus is calculated by determining the area under the demand curve and above the price. In case the demand curve is linear, the total consumer surplus is calculated as the total area of the triangle formed by the quantity of the product demanded, market price, and the P-axis intercept of the curve (Ramli & Shuhaimi, 2016). In the curve shown above, the ongoing market price of cars is $24000 and the yearly demand for cars is 60,000. The consumer surplus for this curve can be calculated as follows.
CS= (1/2). (60000). ($26000) = $780,000 [Area of a triangle= (1/2). (Base). (Height)].
Producer surplus is calculated from the area under price and above supply. In the case of a linear supply curve, the calculation of the area of the triangle formed by supply, market price, and P-axis intercept of a supply curve. A supply curve is provided as an example below.
Figure 2: Supply Curve
Source: (Steinberg, 2013)
In the supply curve shown above, Producer Surplus can be calculated as follows.
PS= (1/2). ($19000). (60000) = $570,000.
Determining the Efficiency of a market from Consumer and Producer surplus involves the concept of total surplus which is the sum of consumer and producer surplus. If consumers as well as producers are benefitting from a market then the market is good and has positive indicators for gains from trade (Walzer et al., 2013). Market equilibrium signifies the highest possible total surplus which is an indicator of the possible gain to consumers. Markets are considered to be efficient when some people are made worse off to make some individuals better off i.e. it is impossible to improve the situation of some people without worsening that of others.
The notion of an efficient market is represented in the graphical depiction shown below.
Figure 3: Producer-Consumer Supply and demand curve
Source: (Steinberg, 2013)
The graph depicts a Producer-Consumer market and the relevant supply and demand curves. The notation P*signifies competitive equilibrium price which is responsible for increasing total surplus and hence provides efficiency to the market.
The efficiency of a market is determined by the quantity of output that is responsible for the total surplus. An efficient market is characterized by the following characteristics. Potential buyers who value a particular product can access the product. An efficient market implies allocation of sales to potential sellers who can offer the lowest cost. Similarly, the buyers in an efficient market value a product more than the seller and thus facilitate surplus. Consumers who don’t value a product also indicate that a seller does not sell the product and thus there is no scope for additional gains from trade. However, an efficient market has certain limitations such as threats of failure. Efficient markets may or may not be equitable and the increase in total surplus doesn’t necessarily mean improvisation of individual surplus in the market.
During the Christmas and fall seasons in 2010, the price of flat-screen TVs underwent a considerable drop in comparison to the prices in 2009. This situation signified consumer surplus. Consumers were under the impression that they had to pay a higher price for the TVs because of the prices in 2009. If a consumer was willing to buy a TV for $500 then they could avail the same TV at $450 in 2010 since the prices had fallen. The difference between both prices signifies consumer surplus (tribunedigital-chicagotribune, 2010).
A real-world example of producer surplus is the sale of coffee. Coffee is a product that is uniformly available across all producers and distributors. However, depending on the place of sale the price of coffee can vary. For example, Starbucks has the privilege to price their coffee higher than that of McDonald’s because customers tend to prefer the coffee at Starbucks. Owing to the strong preference of consumers, they pay higher than reasonable prices for a cup of coffee. The difference between the price consumers pay for coffee and the minimum reasonable price for coffee indicates the producer surplus (Smallbusiness. chron, 2016).
The desire of a government to improve equity can help in fostering the efficiency of a market. Generally, vague property rights and inaccuracies in economic indicators are the reasons that call for government intervention to improve society’s welfare. Proper market infrastructure and interventions at times of inefficiencies in the market are some ways in which governments can contribute to market efficiency.
References
Alguacil, N., Arroyo, J.M. and García-Bertrand, R., 2013. Optimization-based approach for price multiplicity in network-constrained electricity markets.Power Systems, IEEE Transactions on, 28(4), pp.4264-4273.
Anandarajah, G. and McGlade, C., 2012. Modeling carbon price impacts of global energy scenarios. UCL Energy Institute, London, UK
Camejo, R.R., McGrath, C., Miraldo, M. and Rutten, F., 2014. Distribution of health-related social surplus in pharmaceuticals: an estimation of consumer and producer surplus in the management of high blood lipids and COPD. The European Journal of Health Economics, 15(4), pp.439-445.
Ramli, B. and Shuhaimi, M.F., 2016. The Application of Producer and Consumer Surplus Concept and Accounting Method in Estimating Losses Caused by Marine Pollution. OIDA International Journal of Sustainable Development, 9(02), pp.11-22.
Sun, Y., Delucchi, M.A., Lin, C.Y.C. and Ogden, J.M., 2014. The producer surplus associated with gasoline fuel use in the United States. Working paper, University of California at Davis.
Steinberg, R., 2013. Economics 201–Introduction to Microeconomics.
Smallbusiness.chron 2016. What Is a Good Example of a Producer Surplus? [online] Available at: http://smallbusiness.chron.com/good-example-producer-surplus-36378.html [Accessed 5 Apr. 2016].
tribunedigital-chicagotribune. 2010. Flat-screen TV prices to plunge for holiday season. [online] Available at: http://www.chicagotribune.com/news/daywatch/ct-flat-screen-tv-prices-plunge,0,2525333.story [Accessed 5 Apr. 2016].
Walzer, S., Nuijten, M., Wiesner, C., Kaier, K., Johansson, P.O. and Oertel, S., 2013. Microeconomic surplus in health care: applied economic theory in health care in four European countries. Front Pharmacol, 4, p.17.
