Question

• What is consumer surplus? How does it relate to market equilibrium?
• What is the producer surplus? How does it relate to market equilibrium?
• What is a deadweight loss (DWL)?
• How does a tax increase affect both the buyer and seller? How is it related to DWL?

Answer 1

Consumer surplus is a measure of welfare. It is defined as the difference between the price between what a consumer was willing to pay and what actually does he/she pays. The concept was first developed in 1844 to measure the social benefits of public goods. it is generally shown by the price demand graph. Consumer surplus is based on the economic theory of marginal utility, which is the additional satisfaction a consumer gains from one more unit of a good or service. The utility a good or service provides varies from individual to individual based on his own personal preference. The price elasticity and consumer surplus are related in several ways such as, When the demand for a good or service is perfectly elastic, consumer surplus is zero because the price that people pay matches exactly what they are willing to pay. In contrast, when demand is perfectly inelastic, consumer surplus is infinite. In this situation, demand does not respond to a price change. Whatever the price, the quantity demanded remains the same. Are there any examples of products that have such zero price elasticity of demand? Perhaps the closest we get is a life-saving product with no obvious substitutes - in this situation, consumers' willingness to pay will be extremely high.

Producer Surplus is defined as the difference between the amount of willingness to accept and what a producer actually gets. It is shown graphically below as the area above the producer's supply curve that it receives at the price point (P(i)), forming a triangular area on the graph.

Equilibrium Situation:

Consumer Surplus is calculated with the base of the triangle is the equilibrium quantity (Q_E). And the height of the triangle is the amount by which the y-intercept of the demand curve (i.e., the price at which quantity demanded is zero) exceeds the equilibrium price (P_E).

Producer Surplus is calculated with the base of the triangle being the equilibrium quantity (Q_E) and the height being the equilibrium price (P_E).

Deadweight Loss

It is calculated as the total loss incurred in the market due to the market inefficiency or inefficient allocation of resources. When the government took Price Control measures, it results in creating some deadweight loss. It occurs when demand and supply are not in its equilibrium state.

Taxes imposed also creates deadweight loss. if taxes on an item rise, the burden is often split between the producer and the consumer, leading to the producer receiving less profit from the item and the customer paying a higher price. So such situations of the inefficacy of the market create deadweight loss.