Consumer and producer surplus AIMS • • • • Explain the meaning of consumer and producer surplus, as well as social or community surplus Draw a diagram showing maximum social surplus at competitive market equilibrium Explain the conditions for achievement of allocative efficiency at competitive market equilibrium • Social surplus is maximum • Marginal benefits are equal to marginal costs Calculate consumer and producer surplus from a diagram Allocative efficiency in competitive markets ■ ■ ■ ■ ■ Allocative efficiency means the market produces desired goods in the right quantities leading to the maximization of benefits from consumption among households Consumer surplus exists when consumers pay less than they are willing an able to pay for a good Consumers will increase consumption when price falls as there will be additional marginal benefits Producer surplus exists when the price is higher than the minimum price a firm is willing and able to accept As firms increase output marginal cost rises, this in part explains the shape of the supply curve Allocative efficiency in competitive markets ■ ■ At equilibrium in a competitive market, both consumer and producer surplus are maximised allowing the market to achieve allocative efficiency, thus welfare is maximised NOTE – allocative efficiency is a positive statement, it is not a value judgement, nor does it suggest the goods are distributed fairly P Consumer Surplus S = MC Consumer surplus P1 Producer surplus D O Q1 = MB Q Consumer surplus ■ ■ Consumer surplus is the difference between the price a 8 consumer is willing to pay and the price they actually pay, 5 calculated as you would normally calculate the area of a triangle: 0.5(base*height) Alternatively the formula can be viewed as: (value of P intercept – price) x quantity 2 ■ (8-5)x500 = 750 2 = MC = MB 500 Producer surplus (triangle) ■ ■ Producer surplus is the difference between the price a firm is willing to accept and the price they actually receive, 5 calculated as you would normally calculate the area of a triangle: 0.5(base*height) 1 Alternatively the formula can be viewed as: (price - value of P intercept) x quantity 2 ■ (5-1)x500 = 1000 2 = MC = MB 500 Social surplus ■ ■ ■ Social surplus is the sum of producer and consumer surplus It shows the value that trade has brought to society In the case of the (8-5)x500 + (5-1)x500 2 2 = 1750 Producer surplus (trapezium) ■ = MC Producer surplus is calculated differently when the supply curve intercepts the X axis 5 = MB ■ ■ (Quantity + Q Intercept) x Price 2 (500+100) x 5 = 1500 2 100 500 Reality check ■ In reality markets rarely achieve true allocative efficiency due to human error, regular shifts in demand and supply and market failures resulting in welfare loss