Economic Surplus and Efficiency: Study with Video Lessons, Practice Problems & Examples

Economic surplus, the sum of consumer surplus and producer surplus, is maximized at market equilibrium, where marginal benefits equal marginal costs. Deviations from equilibrium lead to deadweight loss, which occurs in cases of underproduction (shortage) and overproduction (surplus). Market failures can arise from price regulations, externalities, monopolies, and high transaction costs, preventing efficient outcomes. Understanding these concepts is crucial for analyzing market dynamics and ensuring optimal resource allocation.

Economic Surplus

Now let's see what happens when we put Producer Surplus and Consumer Surplus together on the same graph. So we're going to have this idea of economic surplus. An economic surplus is the sum of the consumer surplus and the producer surplus, alright? So it's going to be our total surplus here. Economic surplus, we're going to call it our total surplus as well, right? Total surplus. So when are we going to maximize surplus, right? We talk about maximizing a lot, maximizing profit, maximizing revenue, we want to maximize surplus as well here, and that's going to be when the market is in equilibrium. Okay? So when we have that equilibrium, that is when we are going to have maximum surplus. So let's look at that on the graph. Look at this, kind of a standard supply and demand graph here. Right? We've got our price axis, our quantity axis, our downward demand, double d's, upward supply. Right? So what's going on here? We've got our maximum surplus in this case, and I'm going to show you why in a second, but just to be clear, we have this price of P star, right? We are at equilibrium, we've got P star and Q star, our equilibrium price and equilibrium quantity and what do we have? At that price, our consumer surplus is going to be this purple area that I'm highlighting now, right. Everything below the demand curve but above the price, right? That's our consumer surplus, which I'll write out here, and now let's do the same thing with producer surplus. That's going to be everything below the price but above the supply curve, right, and that's going to give us this area in green. Right? So when we add the green area, the producer surplus, with the consumer surplus, that is where we get our total surplus or economic surplus, right? So this is the case where it's maximized, right? We're going to have the most area between the supply and demand curve when we're at equilibrium. So let's go ahead and see a situation where we're not at equilibrium, right? So we're going to have what's called a deadweight loss when we're not at equilibrium. So if we're not at equilibrium, it's called a deadweight loss, that emerges here, and that comes from the inefficiency of not being at equilibrium. Right? So let's go ahead and look on this graph. We're going to see we've got these different prices, right? We had our equilibrium price here, P star and Q star, right? But now let's go ahead and say that the price is set too low, right? And you as a consumer, you're like yeah, low price, I love it. This is great for us. Which is true, you're going to see that. Consumers do benefit from that still, but let's see what happens in this situation. So quantity low here, I'm going to put as well. So I'm going to go ahead and label these boxes, these different areas of the graph. I'm going to call this area A B C D. What do you think about this last one? I'm going to go with E. Sounds pretty good. Alright, so we've got those 5 different areas of the graph, kind of cut off by those dotted lines, right? So let's talk about consumer surplus and producer surplus in each of these situations, and then we'll talk about deadweight loss. So first, at equilibrium, we've got our consumer surplus which is everything above the price, right? So our equilibrium price was right here, right? The P star. So we're going to have this area, and I wouldn't suggest you don't go ahead shading everything because I'm going to be un coloring stuff and we're going to be making different areas out of this graph. So just kind of follow along here and see where I'm going. So that area is going to be our consumer surplus, right? A plus B. You're going to see is our consumer surplus. So I'm going to write it in here. A plus B is the area that makes consumer surplus there and let's go ahead and do the same thing with producer surplus. So producer surplus is everything below the price above the supply curve, right, and that's going to give us this triangle, the one we're used to, right? So remember, in equilibrium, we've got our maximum surplus, which is everything is going to be surplus. So here C plus E are all Producer Surplus in this case. Alright, so I'm going to go ahead and erase these colors and let's do the same thing, at the low price. So now let's talk about consumer surplus and producer surplus at PL, right? Now we're at that low price. So what are we going to see that's happening? Let's talk about consumer surplus first, right? You're like hey low price, I love it, let's go ahead and see what happened to producer surplus or excuse me consumer surplus. So in this case, it's going to be everything above, the price of PL, right? So you might think at first that it's going to be this whole area here including B and D, right? That might be your first guess at what our consumer surplus is going to be, but that's not right because if you think about area B and D, those trades are not happening at the low price, right? If we're at this low price, let's think about this real quick, at this low price, right here, the quantity exchanged is this quantity low, So those exchanges passed to the right that are happening in the area of BND, those didn't happen, right? And if the trade didn't happen, no surplus happened, right? Because it has to the exchange has to happen for the surplus to exist, alright? So that is actually not going to be the area of our consumer surplus because B and D are not part of our surplus, right? Those exchanges didn't happen, there's no surplus there. So what we're going to see is that our surplus, our consumer surplus is going to be this area right here. A and C. Okay? So that area of B and D, those trades didn't happen and you can kinda guess what's going to happen with B and D in a second, alright? So A plus C is now our consumer surplus. Let's talk about producer surplus, right? And as we expected, producer surplus at a lower price, right, when the price goes down, producers would rather have high prices, right? They want to sell it for as high as possible. The price went down, they're going to lose surplus in this situation. So at this low price, it's everything below, the price which is PL, but above the supply curve. And notice what's the only thing in there is just E, right? E is the only area for the producer surplus. So producer_surplus has decreased just like we expected, right? The price went down, producer_surplus decreased, right? And, it looks like consumer_surplus increased, right? That area seems bigger than the A plus B area, the A plus C. So we did gain something as consumers, but at what cost to society, right? So remember in equilibrium, we didn't have deadweight_loss, right? There's no deadweight_loss in equilibrium because we're maximizing efficiency, but in this case, when we have a low price, we're not at our efficient price, right? Our equilibrium price, we are going to have deadweight_loss right here. The deadweight_loss is going to be B and D and this is because those exchanges didn't happen. If the market had set the correct price or if there was yeah if we were at equilibrium we would have got that as surplus, but since we didn't exchange up to the equilibrium quantity, we stopped earlier because of this different price. These exchanges didn't happen and society is worse off for it, right? People that would...

Deadweight Loss and Market Failure

So like I said, deadweight loss happens in cases of underproduction and in cases of overproduction, alright? And I'm going to introduce you to what I call the bowtie of deadweight loss, alright? This is my thing, DWL is sometimes the acronym we use for deadweight loss. I'll probably use it, just to shorten the writing, but let's talk about this bow tie of deadweight loss. We're going to see it in a second. Let's start in this case of underproduction right? So in the case of underproduction which is kind of what we saw in our example before, we have a price that's too low right? We have a price under equilibrium price, right? Equilibrium being right here, \(P^*\) and at this price that's too low we're going to have a shortage right? Because at the low price a lot of people are going to want the product, but the suppliers aren't going to want to supply. So we're going to end up at this quantity right here, right? At this quantity and notice that we have this shortage, right? The people demand that much out here, but the supply is that inner number, right? This is going to be the quantity supplied and this is going to be the quantity exchanged too, right, because the supply is the one that's smaller is the one that's going to be exchanged. So let's go ahead and see what happens here. In this case, just like we saw before we had this deadweight loss here right? These are the trades that didn't happen, that should have happened if the price was correct, right? So I'm going to highlight it in blue, deadweight loss right here, right? And now let's see the same thing in the situation where the price is too high, right? So now we're going to have a situation where the price is above equilibrium, right? This was our equilibrium here. Price equilibrium, right? And now what's going to happen? At this price, we are not going to exchange the same amount. Right? Because only this much is demanded. This is the quantity demanded right here. But the quantity supplied is way out here. Right? Way out there, so they're producing way more than is demanded at this level. So there's going to be a surplus. There's excess supply. They're producing more than is necessary, right? So where is our deadweight loss in this situation? Well in this situation, our deadweight loss ends up being on this side of the graph. Okay? Because we overproduced, right, the overproduction caused there to be wasted resources into this product that could have been better spent somewhere else right. We produced past the equilibrium quantity, we should have just produced up to the equilibrium quantity. So our deadweight loss is going to be this blue area that I'm highlighting now, right? So I just want to point out and this is why I call it the Bowtie of deadweight loss, right? Because the deadweight loss always happens within these areas. I've seen a lot of students mess up and call this the deadweight loss up here or this the deadweight loss down here, right? And that's completely wrong, you're going to fail if you do that, right? So the easiest way I like to think about it is deadweight loss is always going to be in this bow tie. It's either going to be on the left or the right. So here's our bow tie, I'll do it in green, right? This is the deadweight loss bow tie here in green, and it's going to be one of those two triangles. Right? Here's our dude wearing his bow tie. Right. You see it? So the idea here is and I'll just leave it in there, that when we under produce, we're going to have the left side of the bow tie be our deadweight loss and when we overproduce, we're going to have the right side of the bow tie be our deadweight loss. Cool? Alright, so that is what it is, what we see the deadweight loss actually from overproduction as well. So underproduction is not the only problem, overproduction can happen as well. So last thing before we wrap this up is what we call a market failure. When a market fails to be efficient, it's a market failure, right? It's not doing what it's supposed to do, right? We're failing and there's reasons for the market failure, right? What could cause a market failure? First, there could be price or quantity regulations, right? The government can come in and say, hey, the price of this product has to be this amount, right? They could have some reason, that they're trying to set a price. It happens all the time, or quantity regulations, right? The government could say, hey, only this much can be produced of this product. Either way, that can cause a market failure because we're not at equilibrium. It's causing us not to be at equilibrium. Next, we have this idea of externalities. We're going to dive into this topic way more in a different chapter, but externalities is basically cost to people outside transaction. Cost or benefits really. Costs or benefits to people outside the transaction. And the most common example of this transaction. Let's get that word out there. Most common example is pollution, right? So even though you buy this product and it gets supplied maybe that factory that's creating that product is polluting the environment, right? And that pollution is affecting people outside the trade. It's affecting the neighbors of the factory, it's affecting the world in general, so there are these costs that aren't being included, and those are called externalities and we're going to dive into it way more, but these are ways that the market can fail. A monopoly, so a monopoly is when there's only one seller of a product and you can imagine when there's one seller, they're going to have influence over the price. They're the only ones selling this, so they're going to influence what the market price is and we're not going to be at equilibrium in that case, they're going to try and make as much money as they can. And we're going to talk about monopolies a lot more too in a later chapter. So last one here, high transaction costs, and you can imagine that high transaction costs could cause trades to not happen. Imagine if eBay increased their fee to like $100 per trade right, a lot of trades that are happening on eBay wouldn't happen anymore because of these high transaction costs and that would be a failure to the market right, these trades that should be happening are being stopped because of the transaction cost. Alright, so a market failure that's when we're inefficient, we have a market failure. Alright, so let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What is economic surplus and how is it maximized?

Economic surplus is the sum of consumer surplus and producer surplus. Consumer surplus is the difference between what consumers are willing to pay and what they actually pay, while producer surplus is the difference between what producers are willing to accept and what they actually receive. Economic surplus is maximized when the market is in equilibrium, where the quantity demanded equals the quantity supplied. At this point, marginal benefits equal marginal costs, ensuring that resources are allocated efficiently. Any deviation from this equilibrium results in deadweight loss, reducing the total economic surplus.

What is deadweight loss and how does it occur?

Deadweight loss is the loss of economic efficiency that occurs when the equilibrium for a good or service is not achieved. It can happen in cases of underproduction or overproduction. Underproduction occurs when the price is set below the equilibrium price, leading to a shortage. Overproduction happens when the price is set above the equilibrium price, resulting in a surplus. In both cases, the quantity exchanged is not optimal, causing a loss in total surplus that could have been achieved if the market were at equilibrium.

How do price regulations lead to market failure?

Price regulations, such as price ceilings and price floors, can lead to market failure by preventing the market from reaching equilibrium. A price ceiling, set below the equilibrium price, can cause a shortage as the quantity demanded exceeds the quantity supplied. Conversely, a price floor, set above the equilibrium price, can lead to a surplus as the quantity supplied exceeds the quantity demanded. These imbalances result in deadweight loss, reducing the total economic surplus and leading to inefficient resource allocation.

What are externalities and how do they cause market failure?

Externalities are costs or benefits that affect third parties who are not directly involved in a transaction. They can be either positive or negative. Negative externalities, such as pollution, impose additional costs on society that are not reflected in the market price, leading to overproduction. Positive externalities, like education, provide additional benefits to society that are not captured in the market price, leading to underproduction. Both types of externalities result in market failure by causing the market to produce more or less than the socially optimal quantity, leading to inefficiency and deadweight loss.

What is the difference between consumer surplus and producer surplus?

Consumer surplus is the difference between the maximum price consumers are willing to pay for a good or service and the actual price they pay. It represents the benefit consumers receive from purchasing a product at a lower price than they are willing to pay. Producer surplus, on the other hand, is the difference between the minimum price producers are willing to accept for a good or service and the actual price they receive. It represents the benefit producers receive from selling a product at a higher price than the minimum they are willing to accept. Together, these surpluses make up the total economic surplus.