CHAPTER 2 THEORETICAL TOOLS OF PUBLIC FINANCE 51

FIGURE 2-15

(a) (b) (c)

Price, P P P

W W W
S
S

X Z X Z X Z S
PE PE PE

D D Y D

Producer
surplus
Y

Y
Q E Quantity, Q QE Q QE Q

Producer Surplus The producer surplus is the area below the equilibrium market price and
above the supply curve, the shaded area XZY in all three panels of this graph. This represents the
profit earned by firms on all units sold at the market price. As supply becomes more inelastic, pro-
ducer surplus rises; as supply becomes more elastic, producer surplus falls.

theorem makes intuitive sense because social efficiency is created whenever a

trade occurs that has benefits that exceed its costs. This is true for every trans-
action to the left of QE in Figure 2-16: for each of those transactions, the
benefits (willingness to pay, or demand) exceed the costs (marginal cost, or
supply).
Doing anything that lowers the quantity sold in the market below QE reduces
social efficiency. For example, suppose that the government, in an effort to
help consumers, restricts the price that firms can charge for movies to PR,
which is below the equilibrium price PE . Suppliers react to this restriction by
reducing their quantity produced to QR, the quantity at which the new price,
PR, intersects the supply curve: it is the quantity producers are willing to sup-
ply at this price. Producer surplus is now area C, the area above the supply
curve and below price PR. Thus, producer surplus falls by area B E.
On the consumer side, there are two effects on surplus. On the one hand,
since a smaller quantity of movies is supplied, consumers are worse off by the
area D: the movies that are no longer provided between QR and QE were
movies for which consumers were willing to pay more than the cost of pro-
duction to see the movie, so consumer surplus falls. On the other hand, since
consumers pay a lower price for the remaining QR movies that they do see, deadweight loss The reduction
consumer surplus rises by area B. in social efficiency from prevent-
ing trades for which benefits
On net, then, society loses surplus equal to the area D E. This area is exceed costs.
called deadweight loss, the reduction in social efficiency from preventing