consumer-and-producer-surplus

Consumer & Producer Surplus

• Market efficiency and welfare losses in market structures can be considered through the concepts of consumer and producer surplus

• Consumer surplus is the difference between the amount the consumer is willing to pay for a product and the price they have actually paid

  • E.g. If a consumer is willing to pay £18 to watch a movie and the price is £15, their consumer surplus is £3

• Producer surplus is the difference between the amount that the producer is willing to sell a product for and the price they actually do

  • E.g. If a producer is willing to sell a laptop for £450 and the price is £595, their producer surplus is £145

Diagram: Consumer and Producer Surplus

Diagram analysis

• The area between the equilibrium price and the demand curve represents the consumer surplus in the market (ABP_e)

  • The consumer surplus lies underneath the demand curve

• The area between the equilibrium price and the supply curve represents the producer surplus in the market (CBP_e)

  • Producer surplus lies above the supply curve

• When the market is at equilibrium, producer and consumer surplus are maximised

• Consumer surplus + producer surplus = social/community surplus

  • Any disequilibrium reduces the social surplus

Consumer & Producer Surplus in a Monopoly

• Monopoly is typically compared to perfect competition when comparing market efficiency 

  • Due to the lack of competition, monopolies tend to have higher prices and lower output

  • As a result, they have lower levels of consumer surplus and higher levels of producer surplus

Diagram: Consumer and Producer Surplus in a Monopoly

Diagram analysis

Change to consumer surplus

• The monopolist produces at the profit maximisation level of output Q2, where MC=MR (A) and sells their products at a monopoly price of P₂

• In a more competitive environment, such as a monopolistic market, consumers would pay the lower price P₁ where AR=MC (allocative efficiency)

• The loss of consumer surplus due to the monopoly price is equal to shaded triangle – DBC

Change to producer surplus

• Producer surplus is maximised at the profit maximisation level of output (Q₂)

• Compared with monopolistic firms, as quantity falls from Q1 to Q2, there is a loss of producer surplus equal to the shaded triangle (DCA)

• However, at the same time, some of the previous consumer surplus is converted to producer surplus (P₁P₂BD), resulting in a net gain of producer surplus

• The welfare loss is equal to the area of the shaded triangle – ADC

  • The cost to society caused by a lack of efficiency in the allocation of resource

How Price Discrimination in a Monopoly Affects Consumer Surplus

• Price discrimination may increase consumer surplus in lower priced markets and decrease consumer surplus in higher price markets 

Diagram: Consumer Surplus and Price Discrimination in Monopoly

Diagram explanation

• Each train route has an effective monopoly provider

• The overall firm is producing at the profit maximising level of output where MC=MR

  • This point is extrapolated to both market segments on the left by using the lower dotted line

  • The average cost is extrapolated across both sub-markets using the upper dotted line (C₁)

• A higher price for peak travel has been set at P_a & a lower price for off-peak travel has been set at P_b

Diagram: Consumer Surplus and Price Discrimination in Monopoly

Price discrimination is evident from the price inelastic (peak travel) & price elastic demand (off-peak travel)

Diagram analysis

• Each train route in the UK has an effective monopoly provider

• The overall firm is producing at the profit maximising level of output, where MC=MR

  • This point is extrapolated to both market segments on the left by using the lower dotted line

  • The average cost is extrapolated across both sub-markets using the upper dotted line (C₁)
     

• A higher price for peak travel has been set at P_a and a lower price for off-peak travel has been set at P_b

Consumer surplus in the peak period

• Consumer surplus decreases 

  • There is a reduction in consumer surplus for the peak travel (inelastic) market as consumers pay a higher price

    • The consumer surplus in this market is shaded in yellow

Consumer surplus in the off peak period

• Consumer surplus increases 

  • There is an increase in consumer surplus for the off peak travel (elastic) market as consumers pay a lower price

    • The consumer surplus in this market is shaded in yellow

Overall Consumer Surplus

• Price discrimination causes the overall producer surplus to increase

• This means that the overall consumer surplus is decreasing

• Some consumers will benefit and others will lose out, but the end result is that the overall consumer surplus will fall