Economics: Producer and Consumer Surplus

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In this segment we're going to see how the economic pie is divided among the players in the market. Recall that when a buyer and a seller get together and make a trade, the buyer and the seller create economic value. Let's go to an example. Think about that first loaf of bread that we've studied so much. There's a buyer out there who's willing to pay $5.00 for that loaf of bread. That's his reservation price, and if there are no wealth effects and no external benefits, then we imagine that $5.00 is social benefit.
There's a seller out there who's willing to make that loaf of bread for 40 cents with no wealth effects and no external costs, that's society's cost for that loaf of bread. So if we put the buyer and the seller together and they make a deal, then they're creating $4.60 worth of economic value. And I'm going to shade that in my diagram with green to represent economic value. The question is, who gets that economic value? Who really gets the gain from trade in this case?
The answer depends on the price at which this buyer and this seller get together. Let's suppose this buyer and this seller get together and make their deal at a price of $2.10 per loaf of bread. So I'm now going to plug in a price equal to $2.10. If the buyer was willing to pay $5.00 and got the loaf of bread for $2.10, he got a good deal. If the seller was willing to produce the loaf of bread for 40 cents and was able to sell it for $2.10 instead, then the seller got a good deal also. Both of them got some gain from trade. Let's consider now two concepts of economic value that relate to who gets the value.
The first concept is the concept of consumer surplus. Consumer surplus is defined as the difference between the consumer's reservation price and the price at which the consumer actually purchases the good. In this case, our consumer was willing to pay $5,00 for a loaf of bread, and he got the bread for $2.10. The consumer surplus would be $5.00 minus $2.10, or a total of $2.90--$2.90 worth of consumer surplus. What does consumer surplus really mean? Well, imagine that you're going into the bread store and you're thinking to yourself, "I'm willing to pay $5.00 for this loaf of bread." Five dollars is your reservation price. And you go in and you plunk the $5.00 down on the table and the baker gives you a loaf of bread. You're now walking out the door of the bakery. And how do you feel? Well, in some respects you feel no better off than when you walked into the bakery. You gave up $5.00 and you got a loaf of bread that was worth exactly $5.00 to you. You're just as well off as when you went into the store.
But suppose, on your way out of the store the baker calls out after you and says, "Excuse me, sir. We're having a special today. Instead of paying $5.00, we're going to give you a special deal. We're going to give you back $2.90 and you get to take that out with you. Or you can stay in the store and spend it on jam or bagels or something else that pleases you." The 2.90 is your extra bargain, it's your surplus. It's something that you got in addition to the value of the bread. The bread was worth $5.00 to you, you paid the $5.00, you're no better off. But when he gives you the $2.90 back, now you've got something. The $2.90 is your consumer surplus.
If you look at this picture you can see the consumer surplus. It's the difference between the $5.00 you would have paid and the $2.10 that you had to pay. We can shade this area in with red to remind us that it's the consumer's. And I'll use the abbreviation CS to stand for consumer surplus. The consumer surplus in this case is $2.90, $5.00 minus the price you paid of $2.10.
What about the baker? The baker was willing to give you that loaf of bread for 40 cents, but instead, he got $2.10. That's money beyond his costs. This baker got $1.70 more than it cost him to make that loaf of bread, $1.70 more than he needed to make it worth his while to offer you that bread for sale. You can think of this as a kind of a profit. And in this context, the profit has a special name. We call it producer surplus. Producer surplus is defined as the difference between the price the producer received and the price he would have accepted, that is, his cost of making the good. Producer surplus, in this case, is going to be $1.70, which is $2.10 minus the producer's reservation price of 40 cents.
Now notice one more interesting thing--interesting, but not surprising. If you add $1.70 to $2.90 you'll get $4.60, and that's the total economic value created by this trade, $5.00 minus 40 cents. The total economic value is divided between the part that goes to the consumer--that's the consumer surplus, and the part that goes to the producer, that is, the producer surplus. What determines the total amount of economic value created is the difference between the consumer's reservation and the producer's reservation price. What determines the division of that total value into these two parts? Well, that will be the price at which they agree to make the trade. The price at which they agree to make a trade divides that total economic value into the consumer's chunk and the producer's chunk.
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