Question

6. Consumer surplus, producer surplus, and DWL. What are they? Can you determine which one is which given a graph of supply and demand curves? How do economists use them to explain whether an outcome in a market is efficient or not?

Answer 1

6. The CS (consumer surplus) is the amount of surplus gain by consumers which is the difference between the wililngness to pay and the price actually paid. The PS (producer surplus) is the amount of surplus gain by producers which is the difference between the price at which quantity is sold and the cost of production of each unit. The DWL (dead-weight loss) is the measure of inefficiency in case of non-free market equilibrium, which is the difference between the willingness to pay and willingness to sell within the reduced equilibrium quantity and free market quantity.

The graph is as below.

Under free market, the equilibrium would be at point E. In that case, the CS would be area of ACE and PS would be the area of OCE, and there would be no DWL. The CS is identified as the area below the demand curve and above the equilibrium price (price consumers pay), and PS is identified as the area above the supply curve and below the equilibrium price (price sellers receive).

Suppose for any reason the equilibrium alters, such as shown in this graph as imposition of tax from government, the equilibrium would no longer be at E. In that case, the equilibrium quantity in the market would be OG instead of OH (quantity reduced by GH). Also, the price charged to the consumers is OB (who paid OC before) and price received to sellers after tax is OD (who received OC before), and the government collects tax of DB per unit. Hence, the CS would reduce to area ABF and PS would reduce to area ODK. The government would have revenue of area BDKF. But the sum of these surplus is less than before by area EFK, which is the DWL. The DWL is the amount that can be transacted in free market case, but isn't due to tax. Hence, the DWL marks as the measure of inefficiency in the market due to the tax, ie a surplus wasted and received by none in the market due to taxation (or price floors, price ceilings, tax on consumers, etc).