Define Consumer surplus, Producer surplus and Deadweight loss.

Expert Solution

Consumer Surplus is the measurement of consumer benefit in any transaction in the economy. In very simple words, consumer surplus is the maximum amount the consumer is willing to pay for a product and the actual amount paid for the product.

Just as an example, the consumer willingness to pay for a Good X is $10 and the market price of the good is $7. The consumer surplus is therefore $3 [ $10 - $7 ].

Producer surplus, on the other hand, is the difference between the price at which the producer is willing to supply the good and the price that is actually received by the producer.

Just as an example, a producer is willing to supply a good at $5 and the market price of the good is $10, the producer surplus is therefore $5 [ $10 - $5 ].

Before talking about the deadweight loss, it is important to understand the concept of total economic surplus. The economic surplus is the total economic welfare and is the sum of consumer and producer surplus.

Economic Surplus = Consumer Surplus + Producer Surplus

When consumers and producers operate in free markets, there is a equilibrium price set by the "free market forces" and at equilibrium, consumer surplus as well as producer surplus is maximized, translating into total economic welfare or surplus.

However, deadweight loss is the loss that is caused by market inefficiency. It arises due to intervention in free markets by the government through imposition of price ceiling or a price floor. In other words, deadweight loss occurs when supply and demand are not in equilibrium.

Just as an example, when the government imposes a price ceiling to benefit consumers, the quantity demanded increases because of the lower price imposed. However, the quantity supplied declines as producers have less incentive to sell at a lower price. The difference between the quantity demanded and quantity supplied causes a shortage in the economy and the absence of equilibrium between supply and demand leads to deadweight loss.

In the case of deadweight loss, total economic surplus is reduced. When a price ceiling is imposed, producer surplus declines and when a price floor is imposed, consumer surplus declines.

Rahul Sunny answered 2 years ago

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