50 PA R T I INTRODUCTION AND BACKGROUND
then falls as additional consumers derive less and less marginal utility from the
producer surplus The benefit
that producers derive from sell-
ing a good, above and beyond
the cost of producing that
good.
total social surplus (social
efficiency) The sum of con-
sumer surplus and producer
surplus.
First Fundamental Theorem
of Welfare Economics The
competitive equilibrium, where
supply equals demand, maxi-
mizes social efficiency.
good. Finally, for the consumer whose demand (willingness to pay) equals the
price (at point Z), consumer surplus is zero.
Consumer surplus is determined by two factors: the market equilibrium
price and the elasticity of demand. Panel (b) of Figure 2-14 shows the case of a
good with very inelastic demand (that is, where quantity demanded is not very
sensitive to prices), such as basic foods for a low-income community. In this
case, the demand curve is more vertical, so the consumer surplus is a very large
area. Consumer surplus is large because inelastic demand arises from a lack of
good substitutes, so that consumers get enormous surplus out of consuming that
particular good. Panel (c) of Figure 2-14 shows the case of a good with very
elastic demand (that is, where quantity demanded is very sensitive to prices), such
as going to the movies. In this case, the demand curve is nearly horizontal, so
that consumer surplus is a very small area.This is because elastic demand arises
from the availability of very good substitutes. Consumers dont derive very
much surplus from consuming a good for which there are close substitutes.
Producer Surplus Consumers arent the only ones who derive a surplus from
market transactions. There is also a welfare gain to producers, the producer
surplus, which is the benefit derived by producers from the sale of a unit
above and beyond their cost of producing that unit. Like consumer surplus,
producer surplus is easy to measure because every point on the supply curve
represents the marginal cost of producing that unit of the good. Thus, produc-
er surplus is represented graphically by the area above the supply (marginal
cost) curve and below the equilibrium price PE, the shaded area XZY in Fig-
ure 2-15. This area is producer surplus because these are units where the mar-
ket price is above the willingness to supply (the supply curve). Producer
surplus is, in effect, the profits made by the producer.
Panels (b) and (c) in Figure 215 illustrate the impact on producer surplus
of varying the price elasticity of supply, the percentage change in supply for each
percentage change in market prices.When the price elasticity of supply is very
low, so that supply is very inelastic, then the supply curve is more vertical and
producer surplus is very large, as in panel (b). When the price elasticity of sup-
ply is very high so that supply is very elastic, then the supply curve is nearly
horizontal and producer surplus is very small, as in panel (c).
Social Surplus Total social surplus, also called social efficiency, is the
total surplus received by consumers and producers in a market. Figure 2-16
shows the total social surplus for the movie market. The consumer surplus in
this market is the shaded area A D, and the producer surplus is the shaded
area B C E. Thus, social surplus for this market is the sum of the shaded
areas A B C D E.
Competitive Equilibrium Maximizes Social Efficiency
We can use this social surplus framework to illustrate the point known as the
First Fundamental Theorem of Welfare Economics: the competitive
equilibrium, where supply equals demand, maximizes social efficiency. This