Consumer Surplus & Producer Surplus

Study Materials

1. Consumer’s Surplus
Marshall introduced the concept of consumer’s surplus to explain the welfare aspects of pricing. Marshall
defined the concept of consumer's surplus as "excess of the price which a consumer would be willing to
pay rather than go without a thing over that which he actually does pay, is the economic measure of this
surplus satisfaction it may be called consumer's surplus". It is the difference between the total amount of
money an individual would be prepared to pay for a given quantity of a good and the amount actually
paid. Since the amount of money which the consumer is willing to pay indicates his utility, we can use the
price the consumer is ready to pay as a measure of his surplus.
Consumer's surplus = What a consumer is ready to pay - What he actually pays.
= Σ Marginal Utility – Total Outlay.
= Total Utility derived from a product – Total Amount Spent on the same product.
The concept of consumer's surplus is derived from the law of diminishing marginal utility. As we
know from the law of diminishing marginal utility, the more of a thing we have, the lesser marginal utility
it has. In other words, as we purchase more of a good, its marginal utility goes on diminishing. The
consumer is in equilibrium when marginal utility is equal to given price i.e. he purchases that many
number of units of a good at which marginal utility is equal to price (It is assumed that perfect competition
prevails in the market). Since the price is fixed for all the units of the good he purchases except for the one
at margin, he gets extra utility; this extra utility or extra surplus for the consumer is called consumer's
surplus.
Since Consumer surplus is a measure of how much a consumer will give up in terms of money or
alternative purchases to purchase a specified product. A Mercedes buyer may have to eat ramen noodles
for a month to save enough money to buy the desired model. Another buyer may have enough money to
buy at the top price but wants to get a deal and yet another may have no care at all about how much he
spends as long as he can drive away in his heart's desire. Consumer surplus is the amount of money a
consumer is willing to pay above the absolute lowest reasonable price to buy the car. Included in the
consumer surplus is the amount of money the buyer does not spend on other purchases to have enough
money to buy a Mercedes.
The concept of consumer's surplus can also be illustrated graphically. Consider the following figure

MU is the marginal utility curve which slopes downwards, indicating that as the consumer buys more
units of the commodity, its marginal utility falls. Marginal utility shows the price which a person is willing
to pay for the different units rather than go without them. If OP is the price that prevails in the market,
then consumer will be in equilibrium when he buys OQ units of the commodity, since at OQ units,
marginal utility is equal to the given price OP The last unit, i.e., Qth unit does not yield any consumer's
surplus because here price paid is equal to the marginal utility of the Qth unit. But for units before Qth
unit, marginal utility is greater than the price and thus these units fetch consumer's surplus to the
consumer. Marshall's Measure of Consumer's Surplus In Figure above, the total utility is equal to the area
under the marginal utility curve up to point Q i.e. ODRQ. But given the price equal to OP, the consumer

2. actually pays OPRQ. The consumer derives extra utility equal to DPR which is nothing but consumer's
surplus.
We can show the consumer’s surplus with the help of an example.

In the above table we see that as the price falls the marginal utility also declines. At a price of 10, the
marginal utility is zero and at price 8 marginal utility turns negative. At a price of 15, the marginal utility
equals the price and the consumer buys 6 units of the good. The consumer’s surplus would be:
200 – 90 = 110.
Consider Table below in which we have illustrated the measurement of consumer's surplus in case of
commodity X. The price of X is assumed to be Rs. 20.

We see from the above table that when consumer's consumption increases from 1 to 2 units, his marginal
utility falls from Rs. 30 to Rs. 28. His marginal utility goes on diminishing as he increases his
consumption of good X. Since marginal utility for a unit of good indicates the price the consumer is
willing to pay for that unit, and since price is assumed to be fixed at Rs. 20, the consumer enjoys a surplus
at every unit of purchase above 6 units. Thus when the consumer is purchasing 1 unit of X, the marginal
utility is worth Rs. 30 and price fixed is Rs. 20, thus he is deriving a surplus of Rs. 10. Similarly when he
purchases 2 units of X, he enjoys a surplus of Rs. 8 [Rs. 28 - Rs. 20]. This continues and he enjoys
consumer's surplus equal to Rs. 6, 4, 2 respectively from 3rd, 4th and 5th unit. When he buys 6 units, he is
in equilibrium because here his marginal utility is equal to the market price or he is willing to pay a sum
equal to the actual market price. Here he enjoys no surplus. Thus, given the price of Rs. 20 per unit, the
total surplus which the consumer will get, is Rs. 10 + 8 + 6 + 4 + 2 + 0 = 30.
Mathematical Measurement of Consumer Surplus
A demand function p = f (Q) represents the different prices consumers are willing to pay for different
quantities of a good. If the equilibrium price is PE and equilibrium quantity is QE, then consumers who
would be willing to pay more than PE benefit. Total benefit to consumers is called consumers’ surplus.
Mathematically,

Example
Given the demand function P = 42 – 5Q – Q
2
. Assuming that the equilibrium price is 6, the consumer’s
surplus is evaluated as follows
At P = 6, 42 – 5Q – Q
2
= 6
Q
2
+ 5Q – 36 = 0
(Q + 9)(Q – 4) = 0
Therefore, Q = -9 or Q = 4
Since negative quantity is not feasible, we consider Q = 4

3. Importance of Consumer’s Surplus:
• It has great practical importance and is useful in a number of ways:
• In Public Finance it is applied in areas such as taxation
• It helps e Businessman and Monopolist to fix price accordingly to get more profit.
• It helps in Comparing Advantages of Different Places and in assessing welfare related with it.
• It is used to Distinguish between Value-in-Use and Value-in-Exchange:
• Consumers surplus is used Measuring Benefits from International Trade:

Limitations:
(1) Consumer's surplus cannot be measured precisely - because it is difficult to measure the marginal
utilities of different units of a commodity consumed by a person.
(2) In the case of necessaries, the marginal utilities of the earlier units are infinitely large. In such case the
consumer's surplus is always infinite.
(3) The consumer's surplus derived from a commodity is affected by the availability of substitutes.
(4) There is no simple rule for deriving the utility scale of articles which are used for their prestige value
(e.g., diamonds).
(5) Consumer's surplus cannot be measured in terms of money because the marginal utility of money
changes as purchases are made and the consumer's stock of money diminishes. (Marshall assumed that the
marginal utility of money remains constant. But this assumption is unrealistic).
(6) The concept can be accepted only if it is assumed that utility can be measured in terms of money or
otherwise. Many modern economists believe that this cannot be done.

Hicks’ Method of Measuring Consumer’s Surplus
Prof. J.R. Hicks and R.G.D. Allen have criticized Marshallian assumptions of consumer’s surplus and
introduced indifference curve approach to measure consumer’s surplus. Hicksian consumer’s
surplus is explained in the following figure:

The explanation of the concept can be done in two steps.

4. Step1: Assume that the consumer does not know the price of commodity A. This means that there is no
price line or budget line to optimize his consumption. Therefore, he is on the combination S on
indifference curve IC1. At point S, the consumer has ON quantity of commodity A and OB amount of
money. This implies that the consumer has spent FS amount of money ON quantity of commodity A.
Step2: Assume that the consumer knows the price of commodity A. Hence, he can draw his price line or
budget line ML. With this price line ML, the consumer realizes that he can shift to a higher indifference
curve IC2. At equilibrium point C, the consumer has ON quantity of the commodity and OA amount of
money. This implies that the consumer has spent less amount of money than expected for ON quantity of
commodity A. Therefore, CS is the consumer’s surplus.
Therefore Hicksian Consumer Surplus is
(a) The movement from a lower to a higher indifference curve.
(b) The spending of less money on a commodity than expected
(c) The possession of more money income than expected
The Hicks’ version of measuring consumer’s surplus attains results without Marshall’s doubtful
assumption. Hence, Hicks’ version is considered to be superior to that of Marshall’s.

Producer Surplus
(a) Producer surplus is a measure of producer welfare. It is measured as the difference between
what producers are willing and able to supply a good for and the price they actually receive. It is a way we
measure the difference between what a producer actually receives for a product and the minimum amount
that the producer would be willing to accept for that same product. This produces a profit, which we call a
surplus, and is the benefit that producer gets for simply selling that good.
(b) A producer surplus is the extra profit obtained by a producer when he receives a price for a
good that is more than the minimum amount he was willing to accept. This results in a bonus for the
producer because he is getting more profit than what he actually needed to cover his costs.
(c) Producer surplus is the additional private benefit to producers, in terms of profit, gained when
the price they receive in the market is more than the minimum they would be prepared to supply for. In
other words they received a reward that more than covers their costs of production.
(d) Producer surplus is a measure of how high a price a producer can charge for goods over the
lowest price he can reasonably charge, which is the cost of production plus whatever the producer
considers the lowest amount of additional money he must make on the transaction to make it worth the
work of production.
Examples: (a) The seller of a Mercedes normally sets a high price for the car, which the buyer claims is
highway robbery and offers a lower price. The negotiation begins, and the seller sells at the highest price
the consumer will pay for the car. Producer surplus is the difference between the absolute lowest price the
seller will accept for the car and the price actually paid for the car.
(b) Coffee is a good example of a product that is essentially the same across all producers but,
depending on where it is sold, the price of a cup of coffee can vary widely. Starbucks can charge more
than McDonald's for a cup of coffee because coffee drinkers have strong preferences regarding where they
buy their coffee drinks and what they believe is a reasonable price for a cup of coffee. The difference
between the lowest available price for a cup of coffee and the highest price is the producer surplus.
Another example is athletic shoes. Nike shoes are available in stores ranging from high-end sporting
goods stores and department stores to discount stores. The producer surplus is the difference between the
lowest price available and the highest price paid across the economy for Nike shoes.
Consumer & Producer Surplus together at Equilibrium
The following chart shows the perfectly competitive market for oranges. The market is in equilibrium at
the price PE and the quantity QE. As we know, the demand curve indicates consumers’ willingness to pay.
In the chart, the amount that consumers actually are paying is PE — the equilibrium market price for

5. oranges. Therefore, for each transaction that occurs up to QE, consumer surplus is achieved in an amount
equal to the distance between the demand curve and PE. As a result, the shaded area in the chart indicates
the total consumer surplus achieved in the orange market.

To calculate the total consumer surplus achieved in the market, we would want to calculate the area of the
shaded grey triangle. If you think back to geometry class, you will recall that the formula for area of a
triangle is ½ x base x height. In this case, the base of the triangle is the equilibrium quantity (QE). And the
height of the triangle is the amount by which the y-intercept of the demand curve (i.e., the price at which
quantity demanded is zero) exceeds the equilibrium price (PE).
Like consumer surplus, producer surplus can also be shown via a chart of supply and demand. This time,
however, the surplus from each transaction is represented by the distance between the supply curve (which
denotes the lowest price suppliers would be willing to accept) and the market price. The total producer
surplus achieved in the orange market would be represented by the dotted area in the chart. The area of the
dotted triangle (representing producer surplus) is calculated as ½ x base x height, with the base of the
triangle being the equilibrium quantity (QE) and the height being the equilibrium price (PE).

Significance of Consumer and Producer Surplus
When Consumer Surplus is high, this means that consumers have more money ‘left over’ to spend than
they were expecting. They were prepared to pay higher prices for items they needed, and because they
didn’t have to, they have money left over. Some of the effects of a high consumer surplus are:
• Lower crime rate
• Increased sales of non-necessities: vacation travel goes up; movie attendance goes up, etc.
When Producer Surplus is high, this means that producers have more profits than they were expecting.
They were able to sell their products for a higher price than they were willing to sell them for. Some of the
effects of a high producer surplus are:
• More money invested in product research (resulting in better, safer, more efficient products.)
• More money for company growth and expansion (resulting in more jobs and lower unemployment.)

Example: Suppose this time, the demand function is given by p= –50q+ 2000 and the supply function is
given by p = 10q+ 500. Find Consumer & Producer Surplus.
As before, we set the supply and demand equations equal to each other. This time, however, we’ll
be solving for p, instead of q. Once you have the equilibrium quantity, you can find the equilibrium price
by plugging in to either the supply equation or the demand equation. Both functions will give you the
same answer,

6. So we know that Eq= 25. Once you have the equilibrium quantity, you can find the equilibrium price by
plugging in to either the supply equation or the demand equation. Both functions will give you the same
answer.

Since both agree, we are confident that Ep = $750. The equilibrium price is also sometimes called fair
market value.
Consumer surplus is the total amount by which the consumers came out ahead. It’s equal to the area
between equilibrium and demand. Producer surplus is the total amount by which the producers came out
ahead. It’s equal to the area between equilibrium and supply.
Both areas for consumer & producer surpluses can be found using a definite integral. The form the
integral takes is

Consumer Surplus:- Producer Surplus


Producer Surplus is found the same way: The left edge and the right edge are still at 0 and 25, but now the
top of the triangle is our equilibrium price, and the bottom of the triangle is our supply equation p= 10q+
500. So,

7. Example 2: Suppose this time, the demand function is given by q= –0.5p+ 70 and the supply function is
given by q= 0.7p –50. Find Consumer & Producer Surplus.


The left edge of Consumer Surplus is the equilibrium line. And the x-coordinate of that line is our
equilibrium price, or $100. The right edge is the point where the demand function crosses the x-axis. To
find this point, we set the demand function equal to zero and solve:

8. A supply function P = f (Qs) represents the prices at which different quantities of a good will be supplied.
If the market equilibrium occurs at (QE, PE), the producers who would supply at a lower price than PE
benefit. Total gain to producers is called producers’ surplus. Mathematically,