XII.  CONSUMER AND PRODUCER SURPLUS:  NORMATIVE ANALYSIS OF SUPPLY AND DEMAND

How can we measure economic welfare?  Besides indicating a willingness to purchase various quantities at various prices, a demand curve reflects the value consumers place on successive units of the product.  In FIGURE VI the value some consumer places on the first unit of good x is $50 per unit.  That consumer would be no better off, nor no worse off, exchanging $50 for one unit of that good.  This can be represented by the area of the rectangle with a height of $50 per unit and a base of one unit of x.  Some consumer would give up $49 for the second unit, this can be represented by a rectangle with a height of $49 per unit and a base of one unit; someone would give up $48 for the third and so on.  The value the consumers place on the first ten units is represented by the single and the double cross­hatched areas in FIGURE VI. The consumer who valued the first unit by $50 but had to pay $40 to get it received net benefits of $10, which we call the consumer surplus (on the first unit).  The consumer who valued the second unit of the good by $49 and paid $40 for it received net benefits of $9 for that unit.  If the consumers had to pay $40 per unit for each of the first 10 units, which we can see as the area of the rectangle with a base of 10 units and a height of $40 per unit (they would spend $40 x 10 units or $400).  If we subtract the amount paid for the 10 units, the $400 (or the area of the rectangle under the price out to 10 units) from the value that consumers place on the good, the area under the demand curve from the zero^th unit out to the tenth unit, we are left with the area under the demand curve, above the price, on out for however many units the buyers purchase.  This is represented by the double cross­hatched area in FIGURE VI.

FIG VI

Supply curves show the value producers must receive to produce each successive unit.  Since producers have to give up more and more to produce each successive unit, they must receive more for each successive unit.  In FIGURE VII we see that producers must receive $23 for the first unit of x produced (MC = $23), yet the producers receive $40 dollars for that unit, receiving $17 of producer surplus on that unit.  Producers must receive $25 for the second unit, but receive $40, netting $15 of producer surplus, etc. The variable costs of all of the firms will be the area under the supply curve for however many units the firms produce.  The firms receive $400 dollars (the area of the rectangle under the price line out to the number of units sold.  The firms pay variable costs less than this.  The difference between the what the producers receive and what they pay is producer surplus, sometimes referred to as operating profit.

FIG VII

FIG VIII

In FIGURE VIII we see the total consumer and producer surplus as the double cross­hatched area.  If trade were to take place past 10 units, there consumers and producers would receive negative surpluses as we see with area A.  If trade stopped before the tenth unit, there would be consumer and producer surplus that could be had, but the consumers and producers are not receiving, as we see in area B.  Consumer and producer surplus are maximized where the two cross, at equilibrium.  Areas A and B  are both referred to as dead­weight losses or welfare loss triangles, and with taxes as excess burden.  Seldom will trade be carried on past the equilibrium (though it can with negative externalities).  Mostly we will be concerned with cases where there is too little output, too little trade.  Price controls, monopoly power, negative externalities and taxes reduce the quantities traded, below the Pareto optimal levels.  Positive externalities and public goods are also not traded enough (but letting the market alone does not improve things in these cases).

                                                              
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