Today's lesson: Consumer and Producer Surplus

After weeks of depressing economic news, I figured a new economics lesson is needed to get one's mind off the madness that is this country's current financial situation. Today's lesson focuses on an important microeconomic principle, the consumer and producer surpluses. These two things are vital to any economic system working in ways which shall be explained and are vital to understanding how goods are rationed within an economy.

For starters, in definite terms the two surpluses are called so because they are the difference between the market price and either the demand/MR(consumer surplus) or supply/MC(producer surplus). This difference is what a person is willing to pay to buy and a firm is willing to pay to produce. This is illustrated by the first chart to the right of the opening paragraph. At the equilibrium (P* and Q*) there is a surplus of zero because every unit has both a buyer and a seller. Why do competitive markets tend to move towards equilibrium instead of a point to the left where there are willing buyers at a lower marginal cost?

The answer lies in the greed of others. If a firm operates at a point to the left of equilibrium they will make an economic profit(ie, the opportunity cost of being in business if less than the revenue being collected). This does not mean that a firm at equilibrium is not making a profit in the accounting sense, just that the opportunities for the firms at equilibrium would have made as much in other ventures also. Why is this? The next chart will explain why competition drives the surplus to zero. The chart on the right shows that when the market for watches is small, at an output of five units, then the and consumer surplus combined is the sum of taking the CS, 22.5({[7-4]*15}/2) and the PS({[4-2]*15}/2), 15. This 37.5 is the additional benefit to trade. At this first level of output, the firm makes a profit of 25, (the difference between the MR=7, and the MC=2, multiplied by the number of units).

As a result of the economic profit new firms will desire to enter the market, which will increase output to deal with the high demand. In chasing profits, the new firm will cut into the profit of the industry by doubling output, reducing CS to 10([6-4]*10}/2) and PS to 5. The profit decreases from 25 to 15({[6-3]*10}/2). The loss in surplus is the light blue and light green areas, which show how trading benefits both parties because the consumer gets more goods at a lower price while the producer has higher output.

However, for a firm they would ideally wish to reduce consumer surplus as much as possible. Since their profit is the Pmax-Pmin times output or (MR-MC)*Q the difference between the supply and demand curves is important. There are a number of ways for a firm to maximize this difference such as a monopoly, a two tiered pricing system(where units are sold at one price but an entrance fee is charged to reduce the consumer surplus to zero for the most inelastic customers, Costco or Sam's Club would be an example), or forms of price discrimination. Tell me if this made any sense and if you got anything out of it.