Consumer surplus and producer surplus

 

Definition of Consumer Surplus

• This is the difference between what the consumer pays and what he would have been willing to pay.
• For example: If you would be willing to pay £50 for a ticket to see the F. A. Cup final, but you can buy a ticket for £40. In this case, your consumer surplus is £10.

Definition of producer surplus

• This is the difference between the price a firm receives and the price it would be willing to sell it at.
• If a firm would sell a good at £4, but the market price is £7, the producer surplus is £3.

Diagram of 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.

The demand curve shows the maximum price that a consumer would have paid. Consumer surplus is the area between the demand curve and the market price.

If the demand curve is inelastic, consumer surplus is likely to be greater

• Monopolies are able to reduce consumer surplus by setting higher prices
• Price Discrimination is an attempt to extract consumer surplus by setting.

Consumer surplus and marginal utility theory

The demand curve illustrates the marginal utility a consumer gets from consuming a product. At quantity 500 litres, the marginal utility is £0.80 – which indicates the marginal utility is 80p. However, with a price of 50p, the consumer surplus is the difference.

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

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.

Can firms reduce consumer surplus?

1. Firms can reduce consumer surplus if they have market power. – This enables them to raise prices above the competitive equilibrium.
2. In a monopoly, a firm will maximise profits by reducing consumer surplus. See monopoly diagram
3. 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. More on Price discrimination. To completely 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.
4. To gain market power, a firm could advertise to create brand loyalty, this will make demand more inelastic

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.

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