Consumer surplus

Consumer surplus is derived whenever the price a consumer actually pays is less than they are
prepared to pay. A demand curve indicates what price consumers are prepared to pay for a
hypothetical quantity of a good, based on their expectation of private benefit.
For example, at price P, the total private benefit in terms of utility derived by consumers from
consuming quantity, Q is shown as the area ABQC in the diagram.

The amount consumers actually spend is determined by the market price they pay, P, and the
quantity they buy, Q - namely, P x Q, or area PBQC. This means that there is a net gain to the
consumer, because area ABQC is greater that area PBQC. This net gain is called consumer
surplus, which is the total benefit, area ABQC, less the amount spent, area PBQC. Hence
ABQC - PBQC = area ABP.

Declining consumer surplus

Consumer surplus generally declines with consumption. One explanation for this is the law of
diminishing marginal utility, which suggests that the first unit of a good or service consumed
generates much greater utility than the second, which generates greater utility than the third
and subsequent units. A very thirsty consumer will be prepared to pay a relatively high price
for their first soft drink, but, as they drink more, less utility is derived and the price they would
be prepared to pay falls. Therefore, in the above diagram, as consumption rises from zero, at
C, to Q, marginal utility falls. As utility falls, the price that consumers are prepared to pay
declines, causing the demand curve to slope down from A to B.
Some firms can capture this consumer surplus by charging the highest price that consumers
would be prepared to pay, rather than charge price P for all units consumed.
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Producer surplus
Producer surplus is the additional private benefit to producers, in terms of profit, gained when
the price they receive in the market is more than the minimum they would be prepared to supply
for. In other words they received a reward that more than covers their costs of production.
The producer surplus derived by all firms in the market is the area from the supply curve to the
price line, EPB.

Economic welfare
Economic welfare is the total benefit available to society from an economic transaction or
situation.
Economic welfare is also called community surplus. Welfare is represented by the area ABE in
the diagram below, which is made up of the area for consumer surplus, ABP plus the area for
producer surplus, PBE.

In market analysis economic welfare at equilibrium can be calculated by adding consumer and
producer surplus.
Welfare analysis considers whether economic decisions by individuals, organisations, and the
government increase or decrease economic welfare.