What It Means
In order to understand the concept of economic surplus, it is important first to define its two component parts: consumer surplus and producer surplus.
A consumer is an individual who purchases products and services. Before making a purchase, a consumer typically decides how much he or she is willing to spend on a particular good. For example, a college student may decide that a compact disk (or CD) is worth no more than $15. If the price of the CD is $18, the college student will not buy it; if, on the other hand, the CD costs $10, the college student will not only purchase it but will also feel as if he got a good deal in the bargain. The difference between the maximum amount the college student would have been willing to spend ($15) and the amount he ended up spending ($10) is $5. In economic terms, this amount is known as consumer surplus.
A producer, on the other hand, is the individual or company that manufactures products and services. When a producer sells a product, it must determine a price for that product. Imagine that the company that makes the CD must spend $5 to manufacture, market (for example, through advertising), and distribute each CD. The CD producer does not want to lose money selling its product, and so $5 is the minimum amount it would be willing to charge for each CD; to sell it for anything less would quickly put the company out of business. Because the CD producer wants to earn a profit, however, it will want to sell the CD for substantially more than $5. Now, a producer would gladly charge $15, $25, or even $100 for a CD if consumers were willing to spend that much (and if there were no competing businesses offering lower cost CDs). Since most consumers would consider those amounts too expensive, however, the CD producer must establish a price that will be attractive to a large number of consumers. If that price is $10, then the CD manufacturer will earn a profit of $5 on each CD. That profit is also known as the producer surplus.
Generally speaking, then, economic surplus refers to the aggregate (in other words, combined) surplus benefit enjoyed by both consumers and producers in an economic transaction. Under ideal conditions, both consumers and producers would enjoy the maximum financial benefit possible from the goods they buy and sell. The point at which a price stabilizes in an economy, so that both consumers and producers receive maximum surplus, is known as the market equilibrium.
When Did It Begin
The modern theory of consumer surplus was first developed by the English economist Alfred Marshall (1842-1924). In his landmark work Principles of Economics (1890), Marshall examines the relationship between the utility—in other words, the level of satisfaction—a consumer receives from a particular product and the amount of money that consumer is willing to pay for additional units of that product. To illustrate his theory, Marshall considers a man buying tea. In Marshall’s example, the man is willing to pay 20 shillings (and no more) for a pound of tea. When the price of tea is 20 shillings per pound, the man will purchase only one pound of tea. If, however, the price of tea is 14 shillings a pound, then the man will decide to purchase two pounds of tea. Even if 14 shillings represents the maximum amount of money the man is willing to spend on a second pound of tea, he has still derived a “surplus” of satisfaction, in the amount of 6 shillings (that is, the difference between the 20 shillings he would have paid for a pound of tea and the 14 shillings he actually spent) for the first pound of tea.
Looked at another way, if the man is willing to pay 20 shillings for the first pound of tea, and 14 shillings for a second pound, then he is willing to pay a total of 34 shillings for two pounds of tea; in paying only 28 shillings for two pounds of tea, the man enjoys a consumer surplus of 6 shillings. Marshall then examines what might happen in the event that tea costs only 10 shillings per pound. Following the above framework, if the man purchases two pounds, his consumer surplus will rise to 14 shillings: the amount he is willing to pay (34 shillings) less the amount he actually pays (20 shillings). According to Marshall’s theory, this surplus will never decline, even as the man decides to purchase additional pounds of tea. For example, if a third pound of tea is worth 10 shillings to the man, he still enjoys a surplus of 14 shillings if he purchases a third pound of tea: the 44 shillings he would have been willing to pay for three pounds, less the 30 shillings he paid. In a later chapter of Principles of Economics, Marshall explores a similar notion of producer surplus, focusing on the amount of value a producer receives by selling a product at a certain price. Taken together, the concepts of consumer and producer surplus form the foundation of what modern economists call welfare economics (a theory of economics that focuses on the general well-being, or welfare, that individuals experience under certain economic conditions).
More Detailed Information
Economic surplus is closely related to the law of supply and demand. Supply refers to the quantity of a given product that producers are able (or willing) to sell over a range of prices, and demand refers to the quantity of a product that consumers are willing to buy over a range of prices. Since producers sell a product in order to earn as much money as possible (that is, to maximize producer surplus), and consumers buy a product with the aim of saving as much money as possible (thereby maximizing consumer surplus), the product’s price ultimately plays a key role in determining supply and demand. As the price of a product goes up, fewer consumers are willing to purchase it; in other words, demand decreases. Conversely, higher prices will make it desirable for producers to increase supply of their product. According to this model, producers and consumers are at cross purposes: producers want high prices, and consumers want low prices. In an efficient market these conflicting goals achieve a middle ground, so that the needs of both producers and consumers are satisfied. In other words, if supply and demand are balanced—that is, when a large number of consumers are able to purchase a product at a good price, and producers are able to earn a profit by selling to a large number of consumers—then an economic surplus for both consumers and producers will result. In this way, supply and demand work together to determine, and stabilize, the price of a particular good.
Unfortunately markets never achieve ideal efficiency. Various outside factors, known as externalities, can disrupt the balance of supply and demand, in ways that can have a negative impact on economic surplus. In economic terms externalities refer to the effects that an economic activity can have on individuals or groups who do not directly participate in the economic activity. In some cases an externality can be positive, as when a manufacturer opens a new factory, creating jobs and boosting the economy of a specific community in general. In other instances, however, externalities can have a damaging effect on the economy. In recent decades one externality that has exerted a devastating impact on the economy is pollution. In the manufacturing process some degree of pollution is inevitable. Producers must consume fuel in order to operate machinery, which creates air pollution; production also creates waste, which increases the size of landfills and subsequently threatening the ecology of a community or region. In certain respects pollution can undermine the positive effects of an economic surplus by diminishing the overall quality of life of the community. In addition, health problems resulting from pollution can have a direct impact on the economic well-being of a community; for example, lost work time can lead to decreased production while also eroding the purchasing power of the individual consumer who is unable to work to his or her full capacity. In this scenario both consumer and producer surplus are diminished.