The goal of a free-market system is to maximize the benefits and overall value of economic transactions between producers and consumers of products and services. This leads to efficient markets and a wealthier society. Total surplus, also known as economic surplus or economic welfare, is the sum of producer surplus and consumer surplus. A good understanding of this principle of microeconomics and its calculation is vital for a business to make critical decisions that affect its bottom line.
Total Surplus = Consumer Surplus + Producer Surplus .
Overview of Microeconomics
Microeconomics is a social science that studies economic tendencies and how decisions made by producers and consumers of products and services affect market outcomes and impact the supply and demand for resources.
Businesses gather microeconomic data to make decisions that are crucial to their success. Top-level management considers the current state of the economy and looks closely at what the competition is doing. Other variables found through an analysis of data are helpful for pricing products and services, deciding what quantities to produce and which specific consumer markets to target.
Microeconomics also explains what happens when conditions change in a market. For example, it helps explain the law of supply and demand. For example, why stocks of a company rise with increased sales and fall when fewer products are sold.
The Law of Supply and Demand
Supply and demand play an integral role in economic welfare, thus total surplus. Capitalist societies are more efficient because they promote competition, and because people have the freedom to produce and buy whatever they choose. People do things in their self-interest, and they are free to accumulate wealth which in turn maximizes the wealth of the economy. The law of supply and demand state that when prices rise, demand for the product or service decline. On the other hand, if prices drop, the supply must increase to meet increased demand.
What is Consumer Surplus?
Price is a major factor in consumer decisions, but other considerations also impact buying choices. A host of psychological, cultural and societal factors can determine outcomes of producer and consumer exchanges. Consumers buy due to convenience, brand loyalty and even the ability to do business with someone who speaks their native language. Consumer surplus is the difference between what consumers are willing to pay for a product or service and the market price, which is the price they actually pay. Consumer surplus may be illustrated on a graph or in mathematical formulae. On a graph, consumer surplus equals the area above the market price and below the demand curve.
For example, at a three-day home show, wildlife art prints are for sale for $300 each. On the first day, buyer #1 who loves wildlife art would be willing to pay $600 for a leopard print by a famous wildlife artist. She buys the print, and her consumer surplus is $300, the difference between what she was willing to pay. Buyer #2 likes art but he’s not especially fond of wildlife art. Still, he thinks the lion family print would look stunning in his den so he makes the purchase. He would have been willing to pay $400 for it, so his consumer surplus is $100.
What is Producer Surplus?
The main purpose of a business is to generate a surplus that facilitates growth. Producers all know the lowest price at which they would be willing to sell a product or service. Businesses need to at least recoup their costs to produce a product or provide a service. These economic costs are labor and materials plus the cost of the producer's time and effort. Producer surplus is the difference between the lowest price a producer will accept for a product or service and the market price she sells it for, less her economic costs. Producer surplus may be illustrated on a graph or in mathematical formulae. On a graph, producer surplus equals the area below the market price but above the supply curve.
For example, a small craft brewery whose total economic costs are $.50 per can of premium wheat beer sells its beer for $3.00 per can, generating a producer surplus of $2.50 per can.
How Do You Calculate Total Surplus?
Consumer surplus plus producer surplus equals total surplus. Hence, total surplus is the willingness to pay price, less the economic cost. Total surplus is maximized when the market equilibrium price of a product or service is set at the intersection of the supply and demand curve.