Consumer and producer surplus
Consumer surplus (CS) = what buyers are willing to pay − what they actually pay. On a diagram it is the area below the demand curve and above the price.
Producer surplus (PS) = the price sellers receive − the lowest price they would accept (their marginal cost). It is the area above the supply curve and below the price.
With straight lines both are triangles: area = ½ × base × height.
Example: demand P = 100 − Q, supply P = 20 + Q. Equilibrium: 100 − Q = 20 + Q, so Q = 40, P = 60.
CS = ½ × 40 × (100 − 60) = 800. PS = ½ × 40 × (60 − 20) = 800. Total surplus = 1600.
What changes surplus?
- A fall in price raises CS and lowers PS.
- A tax, a subsidy, a price control or a monopoly changes the areas, and often creates a deadweight loss: surplus that no one gets because trades that were worth doing no longer happen.
Allocative and productive efficiency
Allocative efficiency
Resources are used to make the goods people value most, in the right amounts. The condition is P = MC: the value of the last unit to buyers (price) equals the cost of making it (marginal cost). Total surplus is at its maximum.
- If P > MC, too little is produced (a monopoly usually does this).
- If P < MC, too much is produced.
Productive efficiency
Output is made at the lowest possible average cost: the bottom of the AC curve, where MC = AC. No resources are wasted. On a production possibility frontier, any point on the curve is productively efficient.
Perfect competition reaches both in the long run. A monopoly usually reaches neither.
Static and dynamic efficiency
Static efficiency is efficiency at one point in time, with today's technology. It includes allocative and productive efficiency.
Dynamic efficiency is efficiency over time. Firms invest in research and development, new machines and staff training. This lowers the whole cost curve and brings new and better products.
- Supernormal profit can pay for research, so large firms or monopolies may be more dynamically efficient even if they are not statically efficient (the Schumpeter view).
- But a firm with no rivals may become lazy and wasteful (X-inefficiency), so competition can also drive innovation.
Also met: X-efficiency (no slack inside the firm) and technical efficiency (maximum output from given inputs).
Try it
In the last 3D step, slide the price from ₹30 to ₹90. Write down CS, PS and the red deadweight loss at ₹45, ₹60 and ₹75. Where is total surplus biggest? At home: list three things you bought this month and write how much more you would have paid. That is your consumer surplus.
Key formulas and definitions
- Consumer surplus = willingness to pay − price paid; with linear demand CS = ½ × Q × (P_max − P)
- Producer surplus = price received − minimum acceptable price; with linear supply PS = ½ × Q × (P − P_min)
- Total (social) surplus = CS + PS
- Allocative efficiency: P = MC
- Productive efficiency: output at minimum AC (where MC = AC)
- Deadweight loss (triangle) = ½ × (fall in quantity) × (gap between demand and supply at that quantity)
Worked examples
1. Riya would pay ₹500 for a book that costs ₹350. What is her consumer surplus?
500 − 350 = ₹150.
2. Demand P = 100 − Q and supply P = 20 + Q. Find equilibrium, CS and PS.
100 − Q = 20 + Q → Q = 40, P = 60. CS = ½ × 40 × 40 = 800. PS = ½ × 40 × 40 = 800.
3. In the same market a monopoly limits output to 25 units and charges ₹75. Find the deadweight loss.
At Q = 25, demand price = 75 and supply price (MC) = 45. DWL = ½ × (40 − 25) × (75 − 45) = ½ × 15 × 30 = 225.
4. Average cost is ₹30 at 40 units, ₹34 at 30 units and ₹34 at 50 units. Where is productive efficiency?
At 40 units, where average cost is lowest (₹30).
5. A firm sells a product at ₹50 where marginal cost is ₹35. Is it allocatively efficient? What should change?
No, P > MC, so buyers value the last unit more than it costs: too little is made. Output should rise until P = MC.
6. A drug company with a patent charges high prices but spends 20% of revenue on research that halves treatment costs in ten years. Comment on its efficiency.
Statically inefficient today (P > MC, lower output, deadweight loss) but dynamically efficient over time (research lowers costs and creates new medicines). Patents trade short-run loss for long-run gain.
Common mistakes
- Placing consumer surplus below the price line. CS is above the price and below the demand curve.
- Saying allocative efficiency is where P = AC. It is where P = MC; P = AC is normal profit.
- Confusing productive efficiency with making the most output. It means the lowest cost per unit.
- Thinking static and dynamic efficiency always agree. A monopoly may be statically inefficient yet dynamically efficient.