Economic Surplus

Updated on January 28, 2024
Article byPrakhar Gajendrakar
Reviewed byDheeraj Vaidya, CFA, FRM

Economic Surplus Definition

Economic surplus is a relationship between consumers and producers who benefit from a transaction. It is an aggregation of profits acquired by consumers and profits acquired by producers. It is also referred to as community surplus.

Economic Surplus

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It reflects the well-being of a market. The law of supply and demand governs this concept. The main causes of total economic surplus are out-of-sync production, high demand, high taxation, transaction costs, and policies.

Key Takeaways

  • Economic surplus results from an economic transaction that benefits the consumer, the producer, or both. At market equilibrium, both parties register profits.
  • It is divided into two categories consumer surplus and producer surplus. When there is a benefit to the consumer, it is called consumer surplus. In contrast, if producers benefit more, the transaction results in a producer surplus.
  • Attaining market equilibrium is challenging due to certain external factors like taxes, supply, demand, over-production, government policies, and other expenses.
  • This concept is crucial for understanding the effects of government policies, supply, demand, market regulations, and macroeconomics.

Economic Surplus Explained

The economic surplus refers to gains acquired from a monetary transaction. The gains could go in favor of a consumer or a producer. Thus, It is an aggregation of consumer surplus and producer surplus.

In a business transaction, producers often make a hefty profit. But this is at the cost of the consumer, who ends up paying extra. In contrast, there are times when consumers get a good deal and end up saving a considerable amount. But, again, in such bargains, the manufacturers record diminished profits.

But in many real-world scenarios, there is a balance: neither producer nor the consumer has a huge advantage. Rather, both acquire good gains from the transaction. So this culmination of consumer and producer profits is referred to as total economic surplus.

Thus, it is a market study of scenarios that benefit customers and service providers. This study tries to comprehend market trends based on the vital forces of demand and supply.

Every business operates for the sole purpose of profit-making. Thus, value addition, if any, is a by-product. In contrast, customers always look for deals and discounts that fit their budget. A balance in surplus is experienced when prices attain market equilibrium.

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Economic Surplus Formula

The community surplus formula is as follows:

Economic surplus = consumer surplus + producer surplus.

For calculation, consumer and producer surplus are determined individually and then aggregated. It denotes the current market scenario based on supply and demand. Attaining a balance in surplus is challenging—demand and supply must be in equilibrium.

Graph

The total economic surplus is represented on a graph by the intersection of the supply and demand curve. Quantity is represented on the x-axis, and price on the y-axis. The demand curve slopes down from a higher price to a lower quantity. The supply curve ascends from low price to high quantity.

Graph

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The curves intersect, resulting in two triangular regions based on the y-axis. The upper section is referred to as the consumer surplus, and the lower part showcases the producer surplus (also known as the demand surplus).

The point of intersection is referred to as equilibrium. A line is drawn from the intersection toward the x-axis. The point at which the line intersects with the x-axis is known as equilibrium quantity.

Consumer Surplus

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The upper triangle reflects scenarios where the commodity’s price is lower than most consumers are willing to pay. As a result, consumers benefit from such scenarios, hence known as the consumer surplus.

Also, the graph depicts a producer surplus area. This graph reflects scenarios where consumers are overpaying and producers register hefty profits.

Example

Let us assume that Jasmine is a young entrepreneur who launched a new range of handbags. The manufacturing cost of one bag is $45. However, Jasmine’s products are unique, and she is willing to make exceptions. Since she is not ready to go below the break-even point, she decides to sell each handbag at the base price of $72. In addition, she is open to bargaining.

Audrey is a customer who visits the store. Even before entering the store, Audrey has decided she is not willing to go over a $60 budget. Audrey’s decision is a commonly witnessed customer behavior—consumers set a limit in their minds and are stubborn about not exceeding it. Therefore, Audrey bargains with Jasmine to sell the handbag for $50. Jasmine resists initially but eventually gives in.

This is a classic example of total economic surplus. The consumer believes they got the better end of the deal—a surplus of $22. Technically, that would be considered a consumer surplus. On the other hand, if Jasmine had refused to negotiate and secured a purchase of $72, that would be categorized as producer surplus. The manufacturing cost of the handbag is $45, and Jasmine would be left with a $27 surplus.

But Jasmine was clinical in her judgment. Jasmine could have lost the customer altogether by going in for a hard bargain. Jasmine resisted that temptation. Although small, Jasmine made a profit—a producer surplus of $5.

According to the economic surplus definition, Jasmine must settle for a price where she makes curtailed profits, but customers are willing to pay $60. In this example, the accumulated gain of consumers and producers amounts to $27.

Frequently Asked Questions (FAQs)

1. How to calculate economic surplus?

The easiest way to calculate total economic surplus is to subtract total benefits from total costs. It is equivalent to subtracting marginal benefits from marginal costs. The economic surplus graph depicts a triangle based on the y-axis, reaching equilibrium of supply and demand. It is expressed as follows:
Economic surplus = total benefits – total costs.

2. When does the economic surplus reach its maximum?

When data is plotted on a graph, we see a point where the price stabilizes; this is known as market equilibrium. At market equilibrium, surplus maximizes because producers and consumers reap the maximum surplus.

3. What causes an economic surplus?

The main causes are as follows:
– Out-of-sync supply and demand.
– Uneven or orthodox variation in the price of a commodity.
– Overproduction and underproduction.
– Taxes and transactional costs.

This has been a guide to Economic Surplus and its definition. Here, we explain its formula, calculation, graph, and example. You can learn more about it from the following articles –

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