The willingness to pay of each individual consumer determines the demand curve. When price is less than or equal to the willingness to pay, the potential consumer purchases the good. The difference between willingness to pay and price is the net gain to the consumer, the individual consumer surplus.
Total consumer surplus in a market, the sum of all individual consumer surpluses in a market, is equal to the area below the market demand curve but above the price. All other things equal, a rise in the price of a good reduces consumer surplus; a fall in the price increases consumer surplus. The term consumer surplus is often used to refer to both individual and total consumer surplus.
Each potential seller’s cost, the lowest price at which he or she is willing to supply a unit of a particular good, determines the supply curve. If the price of a good is above a seller’s cost, a sale generates a net gain to the producer, known as the individual producer surplus.
Total producer surplus in a market, the sum of the individual producer surpluses in a market, is equal to the area above the market supply curve but below the price. All other things equal, a rise in the price of a good increases producer surplus; a fall in the price reduces producer surplus. The term producer surplus is often used to refer to both individual and total producer surplus.
Total surplus, the total gain to society from the production and consumption of a good, is the sum of consumer and producer surpluses.
Usually markets are efficient and achieve the maximum total surplus. Any possible reallocation of consumption or sales, or a change in the quantity bought and sold, reduces total surplus. However, society also cares about equity. So government intervention in a market that reduces efficiency but increases equity can be a valid choice by society.
An economy composed of efficient markets is also efficient, although this is virtually impossible to achieve in reality. The keys to the efficiency of a market economy are property rights and the proper operation of prices as economic signals. Under certain conditions, market failure occurs, making a market inefficient. Three principal sources of market failure are one party’s attempts to capture more surplus, creating inefficiencies; side effects of some transactions; and problems in the nature of the good.