Consumer and Producer Surplus

Total Surplus

Total surplus is the total net gain to society from trading in a market.
In a highly competitive market, consumer surplus (the difference between how much a consumer is to pay for something and the actual price of that thing) and producer surplus (the difference between the minimum price that a producer will accept and the actual price) are both maximized. The total net gain to consumers and producers from trading in a market is the total surplus.

Perfectly competitive markets exist in textbooks, but nowhere else. A perfectly competitive market would be one where prices are equal to marginal costs (the cost of producing one unit of a good or service) of the last firm in the market. A close second is a highly competitive market, which is a market in which there are many buyers and sellers, in which neither individual firms nor consumers has much power in setting prices, and in which firms are selling a good or service that is largely standardized. The coffee shop market is a good example.

  1. There are a large number of consumers—around 150 million people in America drink coffee on a daily basis.
  2. There are a large number of producers—around 24,000 coffee shops operate in the United States, a number that is expected to continue to increase. Some places, such as Seattle, San Francisco, and New York City, have an especially concentrated market regarding the number of shops vying for customers.
  3. The coffee shops are selling a product that is largely standardized. For a consumer in Massachusetts the price difference between buying a large coffee at either of two popular franchises is 36 cents.
  4. As a result of all of the above, the market in which coffee shops operate in the United States is highly competitive. For this reason, individual consumers and producers in this market have little power in setting prices—instead, they are reacting to changes in the market price for coffee.

In economics, highly competitive markets are also thought to be highly efficient—with so much choice available to consumers, and so many customers for producers to attract, the laws of supply and demand should work especially well.

In highly competitive (efficient) markets, quantity supplied will equal quantity demanded for a particular good as both consumers and producers react to price signals. There will be an equilibrium price—the market price at which supply equals demand—that creates this equilibrium between the amount that producers supply and the amount that consumers demand. Consumer and producer surplus will be maximized, as both parties get the most benefit they possibly can from trading in the market. This is another benefit of these competitive markets getting the price right.

The United States's coffee shop market can be represented on a graph. The different amounts of quantity supplied and quantity demanded at various prices are given. Quantity supplied is equal to quantity demanded at a price of $3 per cup, and the equilibrium quantity at that price is 400 million cups of coffee a day. At the equilibrium price, consumer and producer surplus are also both maximized—the area of each surplus is as large as it can be given the market price. So total surplus, the total net gain to consumers and producers from trading in a market, is maximized at that price.

Equilibrium Price in a Highly Competitive Market

In highly competitive market, quantity supplied (S) is equal to quantity demanded (D). This is shown at an equilibrium (E) price of $3. Total surplus is also maximized at that price, as the amounts of both consumer surplus and producer surplus are as high as they can be.

Deadweight Loss (Efficiency Loss)

When producers either oversupply or undersupply (relative to demand), they face the issue of deadweight loss which reduces total surplus.
Deadweight loss is loss to the economy or less economic activity than there should be caused by resources being used inefficiently. Even in highly competitive markets, quantity supplied doesn't always equate to quantity demanded. There are a number of possible reasons for this—for example, both production and distribution take time, and a host of things can disrupt the process before the final product gets to the consumer.

Likewise, because the production and distribution processes take time, suppliers have to forecast what they think demand will be in order to get goods into stores so they will be available. Stores also forecast and place their orders ahead of time. Just like on the supply side, any number of possible things can affect consumer demand, and this quantity demanded can either be much greater or much less than suppliers anticipated. A graph displaying perfect equilibrium is useful in making production decisions because it shows what happens when a theoretical market gets both production and pricing right.

What happens when they get quantity wrong? Producers have either oversupplied the market (quantity supplied is greater than quantity demanded) or undersupplied the market (quantity supplied is less than quantity demanded). Both are cases of deadweight loss. This is also called efficiency loss, or loss to producers and consumers due to oversupply or undersupply, because the economy is not allocating resources efficiently and the market is not in equilibrium. Both also have an impact on consumer and producer surplus.

Undersupply

When quantity supplied is less than quantity demanded at the equilibrium price in the market, undersupply results. Both consumer and producer surplus are reduced.
Undersupply occurs when quantity supplied is less than quantity demanded at the equilibrium price in the market, resulting in both consumer and producer surplus being reduced. That is, both consumer and producer surplus are less than they would have been at equilibrium. This loss represents an efficiency loss to consumers, who cannot purchase as much as they want, as well as to producers, who are not selling as much as they could. There is unmet demand in the market. At the very least this is annoying for consumers, but it means loss of profit for producers.

Because both consumers and producers are part of the overall economy, this loss in total surplus is called a deadweight loss for the economy—there is less economic activity than there should be. There are also available resources that are not being utilized, since they were not used in the production process—another source of inefficiency.

For example, we know from above that the equilibrium quantity of coffee is, on average, 400 million cups a day. But on this day there are only 300 million cups worth of coffee available. For some reason, consumers can't get 100 million cups of coffee that they want. Likewise, producers aren't maximizing their profits. Not only are they missing out on sales, but consumers would be willing to pay more for the coffee that is available—about a dollar more per cup. But the market price hasn't changed, so sellers can only charge the normal price, until supplies run out and there are only unhappy would-be customers left.

On a graph that shows price on the vertical axis versus quantity of coffee (or any good) on the horizontal axis, a line plotting consumer demand will fall going to the right, as price falls and the quantity produced increases. A line on the same graph plotting producer supply will rise going to the right, as price climbs and the quantity produced increases. The place where these two lines cross is the equilibrium point. Any total quantity produced that is less than the quantity produced at the equilibrium point will be a situation of undersupply.
When a market is undersupplied, both consumer surplus and producer surplus are less than they should be. The loss in total surplus is a deadweight loss to the economy because there is less economic activity than there should be. Consumers have unmet demand, and producers are missing both on sales and on an opportunity to charge a higher price for what coffee is available.

Oversupply

When quantity supplied is more than quantity demanded at the equilibrium price in the market, oversupply results. Thus, producer surplus is reduced.
Oversupply occurs when quantity supplied is more than quantity demanded at the equilibrium price in the market, resulting in producer surplus being reduced. This only affects producers. For example, this time there are 500 million cups of coffee available, but at the market price, consumers only want to purchase 400 million. Consumers will not suffer a loss of surplus this time—they can still get all of the coffee they want.

However, it is costly for producers, as they had production costs that they are not fully recovering through expected sales, as well as extra costs incurred now by having to store this unexpected inventory. It is also a deadweight loss to the economy, because resources were used during the overproduction. Those resources were used unwisely, and now are not available for any alternate uses where they could have been used efficiently.

On a graph that shows price on the vertical axis versus quantity of coffee (or any good) on the horizontal axis, a line plotting consumer demand will fall going to the right, as price falls and the quantity produced increases. A line on the same graph plotting producer supply will rise going to the right, as price climbs and the quantity produced increases. The place where these two lines cross is the equilibrium point. Any total quantity produced that is greater than the quantity produced at the equilibrium point will be a situation of oversupply.
When a market is oversupplied, producers have incurred production costs that they cannot recover, as well as additional storage costs for this unplanned extra inventory. The loss in total surplus is a deadweight loss to the economy because resources were used in production to meet demand that did not exist, and those resources are not available for alternate activity where they could have been used efficiently.