Consumer and Producer Surplus = Community Surplus

In this graph, we can see the equilibrium price of the good is $5.00 and the quantity demanded / supplied is 10 million. The blue triangle above the price line and below the demand curve represents consumer surplus. Consumer surplus is the benefit consumers get from being able to purchase a good or service at a price lower than what they were expecting to pay. In this example, we can see that at a price of $8.50, two million units of the good would be demanded. However, those consumers only have to pay $5.00, and thus they get a benefit from paying less than that which they were prepared. The same is true for the six million units demanded at a price of $6.50. Therefore, the entire blue triangle represents the total consumer surplus for this particular good.

The red triangle below the price line and above the supply curve represents producer surplus. Producer surplus is the benefit producers get from being able to receive a price for a good or service higher than what they were expecting. In this example, we can see that at a price of $1.50, two million units of the good would be supplied. However, those producers get to receive $5.00, and thus they get a benefit from receiving more than that which they were expecting. The same is true for the six million units supplied at a price of $3.50. Therefore, the entire red triangle represents the total producer surplus for this particular good.

Together with consumer surplus, we have the total economic benefit of the transaction, or community surplus (red plus blue triangles). With equilibrium quantity Q* and price P* determined by the forces of supply and demand, there is no way to make one person better off by making someone else worse off. This is called Pareto optimality and means that resources have been allocated efficiently.

This analysis allows us to see supply and demand in a different way. If we consider the supply curve to be the sum of the firms' costs of production for a good or service, we can consider how these costs apply to the community at large and call this the marginal social cost (MSC) curve. If we consider the demand curve to be the sum of consumers' utility in consuming a good or service, we can consider how these benefits apply to the community at large and call this the marginal social benefit (MSB) curve. These terms replace standard supply (S) and demand (D) in market failure analysis.

A minimum price is a government-imposed price control whereby the price is set at a level above the equilibrium (or market-clearing) price. Because producers cannot charge a price below the minimum price, it is also called a price floor (cannot go below a floor). Price floors are set up primarily for two reasons. First, it allows producers to receive more income for the sale of their goods and services, and targets such products that governments consider “good” for society like agricultural products (i.e. milk). Second, when applied to workers, it establishes a minimum wage by which workers are guaranteed a “high” wage to live reasonably in an economy. According to neo-Classical economists, this causes real-wage unemployment (see relevant post).

Before the price floor, the market is in equilibrium at price p* and quantity q*. The government then sets a price floor (pmin), which causes demand at q1 to be less than supply at q2, and is called excess supply. This causes a surplus. Regarding the surplus good, the government can store it, destroy it or attempt to sell it.

A maximum price is a government-imposed price control whereby the price is set at a level below the equilibrium (or market-clearing) price. Because producers cannot charge a price above the minimum price, it is also called a price ceiling (cannot go above a ceiling). Price ceilings give consumers with less purchasing power access to their goods and services, and targets such products that governments consider “good” for society like rent control in a major city like New York. This causes quantity demanded to increase. However, we will see some producers leave the market because the price is too low to supply the product, and quantity supplied decreases.

More explicitly, before the price floor, the market is in equilibrium at price p* and quantity q*. The government then sets a price ceiling (pmax), which causes demand at q1 to be greater than supply at q2, and is called excess demand. This causes a shortage. Regarding the good, the government can supply the g/s itself or subsidize private firms to supply the g/s. In an incredibly misguided example of a real-world application reported by the BBC, Venezuelan President Hugo Chavez placed maximum prices on staple foods like milk and rice to ensure his people would have access to cheaper products starting in 2003. Unfortunately, this (obviously) led to shortages of such important goods.