Efficiency - What is producer surplus? Consumer surplus? Total Surplus? What is a deadweight loss?

Producer Surplus

Producer surplus is a measure of producer welfare. It is the difference between what producers are willing and able to supply a good for and the price they actually receive. The level of producer surplus is shown by the area above the supply curve and below the market price and is illustrated below.

The level of producer surplus is shown by the area above the supply curve and below the market price

At price P1 the level of producer surplus is represented by the area CP1B. This is only part of the total revenue of the firm which is indicated by the rectangle 0P1BQ1

The more elastic the supply curve, the smaller the amount of producer surplus. If the supply curve is perfectly elastic, producer surplus is zero since the price the firm is willing to supply their output at is also the lowest market price.

An increase in market demand would cause an increase in both market price and quantity leading an to rise in total producer surplus available to suppliers.This is shown in the diagram below

Producer surplus can be interpreted as the amount of revenue allocated to fixed costs and profit in the industry. This is because the market supply curve corresponds to industry marginal costs. Recall that firms choose output in a perfectly competitive market by setting price equal to marginal cost. Thus marginal cost is equal to the price P in the Figure at industry output equal to Q. Marginal cost represents the addition to cost for each additional unit of output. As such it represents additional variable cost for each additional unit of output. This implies that the area under the supply curve at an out put level, such as Q represents total variable cost (TVC) to the industry and is shown as the blue area in the diagram.

On the other hand, the market price times the quantity produced (P x Q ) represents total revenue received by firms in the industry. This is represented as the sum of the blue and yellow areas in the diagram. The difference between total revenue and total variable cost, in turn, represents payments made to fixed factors of production (TFC) and any short-run profits () accruing to firms in the industry. (The yellow area in the diagram, i.e. the area between the price line and the supply curve). This area is the same as producer surplus as defined above.

Since fixed factors of production represents capital equipment that must be installed by the owners of the firms before any output can be produced, it is reasonable to use producer surplus to measure the well-being of the owners of the firms in the industry.

Changes in Producer Surplus

Suppose the demand for a good rises, represented as a rightward shift in the demand curve from D to D' in the adjoining diagram. At the original price P1, producer surplus is given by the yellow area in the diagram. (That's the triangular area between the P1 price and the supply curve) The increase in demand raises the market price to P2. The new level of producer surplus is now given by the sum of the blue and yellow areas in the Figure. (That's the triangular area between the price P2 and the supply curve) The change in producer surplus, PS, is given by the blue area in the Figure. (i.e. the area between the two prices and the supply curve) Note that the change in producer surplus is determined as the area between the price that prevails before, the price that prevails after and the supply curve. In this case producer surplus rises because the price increases and output rises. The increase in price and output raises the return to fixed costs and the profitability of firms in the industry. The increase in output also requires an increase in variable factors of production such as labor. Thus one additional benefit to firms, not measured by the increase in producer surplus, is an increase in industry employment.

Consumer surplus

(Graph illustrating consumer (red) and producer (blue) surpluses on a supply and demand chart)

Consumer surplus or Consumer's surplus (or in the plural Consumers' surplus ) is the difference between the price consumers are willing to pay (or reservation price ) and the actual price. If someone is willing to pay more than the actual price, their benefit in a transaction is

how much they saved when they didn't pay that price. For example, a person is willing to pay a tremendous amount for water since he needs it to survive, however since there are competing suppliers of water he is able to purchase it for less than he is willing to pay. The difference between the two prices is the consumer surplus.

The aggregate consumers' surplus is the sum of the consumer's surplus for each individual consumer. This can be represented on a supply and demand figure. If demand is as given as the diagonal line from the price axis to the quantity axis, consumers' surplus in the case of a the initial supply curve (S0) is the triangle above the line formed by price P0 to the demand line (bounded on the left by the price axis and on the top by the demand line). If supply expands (to S1), the consumers' surplus expands, to the triangle above P1 and below the demand line (still bounded by the price axis). The change in consumer's surplus is difference in area between the two triangles, and that is the consumer welfare associated with expansion of supply.

Deadweight Loss

A simple definition is the social surplus not realized because resources are misallocated.

In economics. a deadweight loss (also known as excess burden ) is a loss of economic efficiency that can occur when equilibrium for a good or service is not Pareto optimal. In other words, either people who would have more marginal benefit than marginal cost are not buying the good or service or people who would have more marginal cost than marginal benefit are buying the product.

Causes of deadweight loss can include monopoly pricing (see artificial scarcity ), externalities. taxes or subsidies (Case and Fair, 1999: 442), and binding price ceilings or floors. The term deadweight loss may also be referred to as the "excess burden of monopoly" or the "excess burden of taxation ".

For example, consider a market for nails where the cost of each nail is 10 cents and that the demand will decrease linearly from a high demand for free nails to zero demand for nails at $1.10. In a perfectly competitive market, producers would have to charge a price of 10 cents and every customer whose marginal benefit exceeds 10 cents would have a nail. However, if only one producer has a monopoly on the product, then they will charge whichever price will yield the highest profit. For this market, the producer would charge 60 cents and thus exclude every customer who had less than 60 cents of marginal benefit. The deadweight loss is then the economic benefit forgone by these customers due to the monopoly pricing.

Conversely, deadweight loss can also come from consumers buying a product even if it costs more than it benefits them. To see this, let's use the same nail market, but instead it will be perfectly competitive with the government giving a 3 cent subsidy to every nail produced. This 3 cent subsidy will push the market price of each nail down to 7 cents. Some consumers then buy nails even though the benefit to them is less than the cost of 10 cents. This unneeded expense then creates the deadweight loss.

Also, an important distinction should be drawn between Hicksian and Marshallian deadweight loss. The latter is related to the concept of consumer surplus. such that it can be shown that the Marshallian deadweight loss is zero where demand is perfectly elastic or supply is perfectly inelastic. On the other hand, Hicks analysed the situation through indifference curves and noted that when the Marshallian Demand Curve exhibits perfect inelasticity, the policy or economic situation which caused a distortion in relative prices will have an income effect and that this income effect is a deadweight loss.


Santerre, Neun, Health Economics

Sample Questions

1. Draw a graph and label the are where there is producer surplus.

2. Suppose less people find it necessary to get as flu shot one season, when the season before they all got them. What would this produce? Draw a graph and explain.

3. if Eli Lilly decides to only produce x amount of a drug when the could produce more and the effect is that society is shorted what they could receive. What is this called and explain.

This is deadweight loss. Deadweight loss is the amount society loses out on when less is produced than possible.

Source: healthecon.wikispaces.com

Category: Forex

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