The expressions consumer surplus and producer surplus spring from economists’ lips when they attempt to discuss the economic value of an item. They endorse these two indicators as insights into the willingness of the purchaser or of the provider to alter their positions to trade goods for money.
A company would be thrilled to know how much a consumer would be willing to pay for an item and would set the product price as that level. However, the interest of the buyer varies with the individual, who will rarely express accurately how far he will go to acquire the item. Consumer surplus represents the difference between the maximum price a purchaser would secretly be willing to pay and the amount that he ends up paying. A large consumer surplus indicates that the customer thinks he received a good deal and therefore is very satisfied.
The challenge of the producer resides in knowing what price to set. She knows that the price needs to exceed the cost of making the goods. Beyond this threshold, choosing the price may become a speculative game. Producer surplus represents the price difference between what the seller would secretly be willing to accept for trading the product or service and what she receives from the customer.
How would economists know how much a consumer would be willing to pay and how little a producer would accept in return since these numbers tend to be private choices? They rely on economics principles called the supply and demand laws from which they derive consumer and producer surplus. These laws stipulate that if the product is rare but in demand, people will be willing to pay a high price. Similarly, a product that is abundant and easy to acquire will tend to have a lower price.
When product demand is plotted as a function of price, the curve is typically ascending. Similarly, when product supply is plotted as a function of price, the graph is descending. Consumer and producer surplus can be calculated from these supply and demand curves. These indicators represent the graphical area captured between the two curves, the space above the transaction price being the consumer surplus and the one below the producer surplus.
The values of these two indicators range from zero to infinity. For instance, if the amount of goods is fixed such as the number of concert tickets to see a famous entertainer, consumers will be willing to pay resellers a very high price to secure a seat at the concert. All individuals who bought tickets at the normal price several months prior to the concert are the most satisfied (high consumer surplus). If the supply was elastic and for each request, a producer could generate more tickets, such as with an auditorium of infinite size, the consumer surplus would approach zero.
These economic indicators find their purpose in welfare economic analyses where agencies study how consumers or producers would be impacted if new government policies or taxes were to be introduced to optimize and better distribute the welfare of consumers and producers.