Summary
Firms in a perfectly competitive market may encounter some problems that can decrease their competitiveness and may even force them out of the market. The way they deal with problems will determine whether they can stay in the market. In this Learning Path we learn about these problems, how firms’ cost structures change, and how an equilibrium is reached in the market.Surplus in economics refers to the profits (in terms of money or welfare) an individual or group of individuals is capable of extracting from the correct functioning of markets. Welfare economics analyses these surpluses in order to determine whether a market structure is socially optimal. From a microeconomic point of view, we can differentiate between consumer and producer surplus, which jointly form what is known as total or economic surplus, also known as total welfare. Let’s analyse them separately.
Consumer surplus:
Consumer surplus is quite easy to understand, since it’s the difference between how much someone is willing to pay for a given quantity of goods, an how much they actually pay. In this case, the demand curve is given by the willingness to pay of consumers, how much they will pay for a good.
Let’s consider the market for books, and that we have three potential customers: Arthur, Bertil and Carl. Arthur is willing to pay less than $25 for a book, Bertil would pay less than $20 and Carl would pay less than $15. If price is set at $25, no one buys books. When the price drops to $20, Arthur buys a book, and Arthur’s consumer surplus corresponds to area A. Note that this area equals $5, being this the difference between how much he was willing to pay ($25) and how much he actually pays ($20). If the price drops again, this time to $15, Bertil buys a book. In this case, Bertil’s consumer surplus corresponds to area B. It must be noted that, since the price of a book dropped even more, Arthur’s consumer surplus increased by A’. Both B and A’ equal $5. The same happens when Carl buys a book when price drops to $10. Consumer surplus, understood as the sum of all individual consumer surpluses, corresponds to area A+A’+A’’+B+B’+C.
When we repeat this process with a far greater number of buyers, we get a nice, straight demand curve. Now, let’s say the price for a given good is set at p0. In that case, consumer surplus is area CS. When price drops to p1, quantity sold increases. On the one hand, there is an increase on the consumer surplus of initial consumers, being this equal to area CS’. On the other hand, new consumers are willing to buy, being their consumer surplus nCS.
Producer surplus:
This is the exact opposite concept, since in this case we examine the market from the producers’ point of view. Producer surplus is the difference between the price the producer is paid and the cost of production.
Let’s consider again the market for books, now from the perspective of three producers: David, Edward and Frank. The supply curve corresponds to each producer’s costs of production, being $2 for David, $4 for Edward and $8 for Frank. If the price is lower than $2, no one will supply books since they’ll incur in losses. Now, if the price increases to $4, David sells a book, since he’ll be able to make a profit from the sale. This profit corresponds to D, his producer surplus. If the price increases to $8, Edward will also sell a book, having a producer surplus of E. In this case, David’s producer surplus will increase by $4 (area D’). The same will happen when the price gets over $8, let’s say $10. Producer surplus, understood as the sum of all individual producer surpluses, corresponds to area D+D’+D’’+E+E’+F.
When we repeat this process with more sellers, we get a straight supply curve. Now, let’s say the price for a given good is set at p0. In that case, producer surplus is area PS. When price increases to p1, quantity sold increases. On the one hand, there is an increase on the producer surplus of initial producers, being this equal to area PS’. On the other hand, new producers are willing to sell, being their producer surplus nPS.
Total welfare:
Total welfare, also known as economic or total surplus, is equal to the sum of both consumer and producer surpluses. It can be understood as the surplus of society, since both consumers and producers are getting something from the exchanges taking place in the market.
The analysis of economic surplus is used to determine the total loss of welfare when comparing a perfectly competitive market to other market structures, such as monopolies or oligopolies. It is also used to analyse the impact of the implementation of new taxes.
