A desirable objective of an economic system is to maximize the well-being of society. Do free markets do that? To answer that question, buyers must benefit from what they buy and sellers must benefit from what they sell. When people buy something, they generally pay less than what they were willing to pay for the good or service: the difference between the willingness-to-pay price and the market price is the consumer surplus. Likewise, sellers can sell a product at a higher price than their economic cost to produce a product: the difference between the economic cost and the market price is the producer surplus.
Consumer Surplus = Willingness to Pay Price – Market Price
Producer Surplus = Market Selling Price – Economic Cost
To measure total economic welfare, we can add the consumer surplus to the producer surplus to arrive at the total surplus.
Total Surplus = Consumer Surplus + Producer Surplus
Note that in the above equations for consumer surplus and producer surplus, the price paid is a common term to both. Since the price paid is a positive term in the producer surplus and a negative term in the consumer surplus, the price paid is canceled out resulting in the following equation for total surplus:
Total Surplus = Willingness to Pay Price - Actual Purchase Price + Actual Selling Price - Economic Cost
Total Surplus = Willingness to Pay Price – Economic Cost
Economic costs refer to not only the seller's cost of materials and labor, but also the opportunity cost of the seller's time and effort. Hence, economic cost includes a normal profit.
If the product price is higher than the market price, then the producer surplus increases, but only at the expense of the consumer surplus. If the price is lower than the market price, then consumers enjoy increased consumer surplus, but only at the expense of the producers. Of course, this assumes that the buyers will buy the entire quantity at the higher price or that producers will produce the quantity demanded at the lower prices. However, a price higher than the market price will lead to a surplus, because the price is higher than what many consumers are willing to pay, and if the price is below the market price, then shortages will be created, because at lower prices, producers are only willing to produce a quantity that is less than demand. So, in actuality, shortages and surpluses will reduce the total surplus. Therefore, total surplus is maximized when the price equals the market equilibrium price.
In competitive markets, only the most efficient producers will be able to produce a product for less than the market price. Hence, only those sellers will produce a product. This is what results in the most efficient allocation of economic resources. Looking at the graph, it can easily be seen that as long as the product price is below the market equilibrium price, increasing the quantity of the product increases total surplus. Once the price rises above the market equilibrium price, then total surplus either starts to decline or no longer increases. Hence, total surplus is maximized at the market equilibrium price.
This is why competitive, free markets allocate resources most efficiently. It also explains why centrally planned economies result in poor allocation of resources, since it would require that the central planners know what the producer and consumer surplus of the entire market is for every product and service. Naturally, this is not possible, which is why centrally planned economies are extremely inefficient.
Market Failure and Externalities
There are several factors that cause significant deviations from the above idealized portrayal of total surplus. The 2 most important factors are the lack of perfect competition and externalities.
The discussion about total surplus assumed that markets are competitive. However, in reality, many markets are not competitive. Either buyers or sellers may have market power, or the ability to influence market prices to their advantage. In these cases, supply and demand reaches an equilibrium that favors the holders of the market power. When the market deviates from perfect competition, then there is said to be market failure. In cases of monopoly, where the supplier of the product has pricing power, the supplier can increase his producer surplus by charging a higher price than the equilibrium price, but that increased producer surplus comes at the price of reduced consumer surplus. In cases of monopsony, where the buyer has market power, the buyer can increase its consumer surplus at the expense of producer surplus. Moreover, imperfect competition creates a deadweight loss, because some consumers and firms will not enjoy the benefits of the products and services subject to imperfect competition.
The other assumption is that total surplus only measures the benefit of the good itself. It does not account for externalities, which are effects created by the production or consumption of the product that can also affect people who are not participants in the market. Pollution is a classic example. The production of most goods and services involves the generation of pollution, a cost that is not factored in as part of the production cost. Likewise, consumer surplus can be diminished by the negative effects of externalities unrelated to the benefit of the product itself. Because the externalities have no specific relationship to the product, consumer surplus does not account for these externalities. For instance, pollution affects not only people who have no interest in the product, but also affects the producers who supply the product and the consumers who buy the product. These negative effects are not accounted for in either the consumer or producer surplus, and, therefore, are not a factor in the total surplus.
Despite the simplifying assumptions in the analysis of consumer, producer, and total surplus, these economic concepts provide useful tools in welfare economics, which is the study of how economics impacts the welfare of society, yielding useful insights into how the economy works to benefit the people.