This slideshow explains the meaning of consumer and producer surplus and uses the terms to show the deadweight loss produced by a tax or other government interventions

1. An Economics Tutorial from
Ed Dolan’s Econ Blog
Consumer Surplus, Producer
Surplus, and Deadweight Loss
July 9, 2017
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to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like
the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishing.

2. Interpreting the demand curve
A demand curve for any good, say wheat,
can be interpreted in either of two ways
 How much will buyers plan to purchase
at any given price?
 What is the subjective value to the
buyer of the marginal unit purchased,
that is, what is the most the buyer
would pay for that unit?
July 8, 2017 Ed Dolan’s Econ Blog

3. Subjective value of the marginal unit decreases
 Notice that the subjective value of the
marginal unit purchased decreases as
the quantity increases
 For example, this consumer would be
willing to pay up to 30 cents per kilo for
the third kilo, but not more than 20
cents per kilo for the ninth kilo
July 8, 2017 Ed Dolan’s Econ Blog

4. Consumer Value
 Suppose a consumer buys 9 kilos of
wheat
 The total value to the consumer of this
much wheat is measured by the area
ABCD lying below the demand curve
 This area represents the sum of the
subjective values of each marginal unit
purchased
July 8, 2017 Ed Dolan’s Econ Blog

5. Consumer Surplus and Expenditure
Suppose the consumer buys the 9 kilos at
a uniform market price of 20 cents per
kilo
 Total consumer value may then be
divided into two parts:
 The rectangle AECD (9 kilos times 20
cents per kilo) represents consumer
expenditure (also revenue to the
producer)
 The triangle BCE, which is the
difference between total consumer
value and expenditure, is called
consumer surplus
 Consumer surplus is the difference
between what consumers actually pay
and the maximum they would have
been willing to pay
July 8, 2017 Ed Dolan’s Econ Blog

6. Interpreting the supply curve
The supply curve also can be interpreted in
either of two ways:
 How much will producers plan to supply
at a given price?
 What is the minimum producers would
accept to supply the marginal unit,
based on the opportunity cost of
supplying it? We can call this the
marginal cost, or variable cost of the
marginal unit?
 Notice that the marginal cost of each
additional unit increases as more is
produced
July 8, 2017 Ed Dolan’s Econ Blog

7. Producer surplus and variable cost
Total revenue AECD, can be divided into
two parts:
 The height of the supply curve
represents the variable cost of each
added unit, so the trapezoid AFCD
represents total variable cost
 The difference between revenue and
total variable cost (triangle FCE) is called
producer surplus
July 8, 2017 Ed Dolan’s Econ Blog

8. The meaning of producer surplus
Producer surplus can be thought of in two
ways
 It is the difference between the revenue
producers receive and the minimum
they would have been willing to accept,
at the margin, to supply each additional
unit
 It is also the part of revenue that
producers have available to cover fixed
costs and profit (or rent)
July 8, 2017 Ed Dolan’s Econ Blog

9. Value added (gains from trade)
The combined surplus (adjusted for fixed
costs) represents the total value added
or gains from trade
 Producer surplus is the value that
producers gain compared with using
the same variable resources to produce
other goods
 consumer surplus is the value that
consumers gain compared with using
the same money to buy other goods
July 8, 2017 Ed Dolan’s Econ Blog

10. Value added must be shared
 Total value added must be shared
between producers and consumers—
otherwise both would not have an
incentive to engage in voluntary trade
 When both sides gain from trade,
market exchange is a positive-sum
game—a game in which all players are
made better off as a result of their
participation
July 8, 2017 Ed Dolan’s Econ Blog

11. Effects of a Tax on Price and Quantity
 Suppose that the equilibrium price of
soap is $12 per carton, based on the
demand curve and supply curve S0
 Now suppose the government puts a
tax of $6 per carton on soap.
 The supply curve, as seen by consumers is
now S1, since they must pay $6 more per
carton to get any given quantity of soap
 The supply curve (cost curve) for producers
is still S0
 The new equilibrium quantity is 6
cartons
 Price paid by consumers is $15
 Price received by producers is $9
 Government tax revenue is $6 per carton
July 8, 2017 Ed Dolan’s Econ Blog

12. Effects of a Tax on Consumer and Producer Surplus
 Before the tax:
 Consumer surplus was A+B+D
 Producer surplus was A’+C+E
 After the tax:
 Consumer surplus is D
 Producer surplus is E
 Government tax revenue is A+A’, equal to
the tax per unit times the new quantity
 Distribution of tax burden
 New price of $15 paid by consumers is $3
higher than before the tax, so consumers
bear half of the burden
 New price of $9 received by producers is
$3 less than before, so producers bear half
the burden of the tax
July 8, 2017 Ed Dolan’s Econ Blog

13. Deadweight Loss from a Tax
 Before the tax, consumer surplus
included area B and producer surplus
included area C
 After the tax, areas B and C are not
included in consumer surplus or
producer surplus or government
revenue
 B and C are lost to the economy but
gained by no one. Economists call this
loss of consumer and producer surplus
a deadweight loss
July 8, 2017 Ed Dolan’s Econ Blog

14. Deadweight Loss from a Tax
 Before the tax, consumer surplus
included area B and producer surplus
included area C
 After the tax, areas B and C are not
included in consumer surplus or
producer surplus or government
revenue
 B and C are lost to the economy but
gained by no one. Economists call this
loss of consumer and producer surplus
a deadweight loss
July 8, 2017 Ed Dolan’s Econ Blog

15. Deadweight Loss from an Output Cap (1)
 Other government interventions can also
produce deadweight losses
 Suppose the government imposed an
output cap allowing producers to make
only 6 thousand bottles of wine a year,
instead of the original equilibrium quantity
of 9 million
 Given the limited quantity, consumers
would bid up the price from $24 to $30
 Consumer surplus would decrease from
A+B+D before the cap to just D after the cap
 Producer surplus would be A + A’+E after the
cap compared with A’ + C + E before the tax
July 8, 2017 Ed Dolan’s Econ Blog

16. Deadweight Loss from an Output Cap (1)
 Producers would gain the amount A at the
expense of consumers
 However, the gain to producers (equal to
A-C) would be less than the loss to
consumers (equal to A+B)
 The output cap would therefore produce a
deadweight loss of B + C, which is the
area of surplus that is lost to consumers
and producers, but gained by neither, as
a result of the output cap
July 8, 2017 Ed Dolan’s Econ Blog

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