Equilibrium and welfare

Economic welfare, as measured by consumer and producer surplus, is maximised at market equilibrium price and quantity.

At equilibrium, consumer surplus is maximised at area X A P, and producer surplus is maximised at P A K.

A non-equilibrium price, at P1, causes demand to contract and consumer surplus to shrink while producer surplus increases. However, there is a net welfare loss of area: B, A, C.

Here, surplus shrinks. At a lower price, at P2, supply contracts, so that output is at Q1. Producer surplus shrinks, but consumer surplus increases. However, the net effect is for welfare to fall to area: B, A, C.

An increase in demand raises welfare

An increase in demand raises both consumer and producer surplus. An increase in demand will raise the market price and increase output, withe the result that consumer and producer surplus increase.

Lower demand lowers welfare

A decrease in demand will reduce the market price and reduce output resulting in a fall in both consumer and producer surplus.

Increases in supply increase welfare

An increase in supply will reduce the market price and increase output, resulting in an increase in consumer and producer surplus.

Decreases in supply reduce welfare

Conversely, a decrease in supply will increase the market price and reduce output - both consumer and producer surplus fall.