Here is an elaborated discussion on consumers and producers surplus in order to evaluate the welfare effects of changes in government policy.
In a free, competitive market, where there is no government intervention of any type, consumers and producers buy and sell at the prevailing market price. But some consumers feel that they are getting more than what they are paying for. This means that for them the value of the good exceeds the market price.
So they would be ready to pay more if they were forced to. Consumers’ surplus is the total benefit of value that consumers receive over and above the price they pay for the good they buy.
Fig. 2.14 shows that the first consumer is ready to pay a price of P1 for Q1, the second consumer a price of P2, for Q2. But the third consumer pays exactly P0 which is the market price for Q0. So the first consumer enjoys a net benefit of P1 – P0.
The second consumer drives a net benefit of P2 – P0. But the third consumer values the good at exactly the market price P0. He is at margin of decision making — indifferent between buying or not buying the good. In case the market price rises marginally, he will go without it. It is because P0 is the maximum value of commodity to him.
For the market as a whole consumers’ surplus is measured by the area below the demand curve but above the market price, by the triangular area P0DE. Since consumers’ surplus
measures the total net benefit to the consumer (i.e., difference between total valuations in terms of utility derived less total cost in terms of expenditure made) we evaluate the effect of government intervention in a free market in the form of price control by measuring the resulting change in consumers’ surplus.
This indeed measures the loss to consumers’ from government intervention. It may be noted that price fall leads to an increase in consumers’ surplus and price increase leads to a fall in consumers’ surplus.
Some producing units are producing commodity at the margin, i.e., at a cost just equal to the market price. More efficient producers, having lower cost per unit, could produce the same commodity at less than the market price. So they would still produce and sell the commodity if market price were lower.
These producers, therefore, derive a surplus (or make a gain) by producing and selling at the prevailing market price. For the producing unit, this surplus is the difference between the market price received by it and its marginal cost of production. It may be noted that a price fall leads to a fall in producers’ surplus and a price increase leads to an increase in producers’ surplus.
For the market as a whole producers’ surplus (or what is often called economic rent) is the area above the supply curve but below the market price. This is the benefit that efficient (lower-cost) producers derive by producing and selling the commodity at the market price. In Fig. 2.14 this is the triangular area SP0E. Since producers’ surplus measures the total net benefit to producers, the welfare effects of a government intervention on producers can be evaluated by measuring the resulting change in producers’ surplus.
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