Sold Fast: Price Tags and the Impact on Consumer and Producer Surplus

SOURCE: Left: Shopkeeper John Wanamaker, ©lbusca / DigitalVision Vectors / Getty Images. Right: Wanamaker’s Philadelphia store, a converted railroad station nicknamed the “Grand Depot,” ©lbusca / DigitalVision Vectors / Getty Images.

The consequences of Wanamaker’s change were immediate. With price transparency, customers and clerks saved time, making the market much more efficient. As visitors of the Philadelphia fair went home, they took Wanamaker’s idea with them, and businesses around the world adopted his innovation.

Price Tags and Consumer Surplus

Wanamaker’s idea brought to life a microeconomic concept that English economist Alfred Marshall outlined in 1890—consumer surplus. Imagine going to a store to buy an item. You have an idea of how much you are willing to pay, and, finding the product’s price tag, you see it’s lower than your expectation. You snatch it up believing you snagged “a deal.” Now say the next customer is willing to pay a price that’s lower than what you were willing to pay but still higher than the price listed. That buyer also thinks they are getting a deal, but it’s less than the deal you think you snagged.

These consumer preferences, prices, and exchanges can be arranged in a graph. Figure 1 below shows a sample of people and the prices they are willing to pay for a box of Valentine’s Day chocolates for their partner. Knowing he’s running out of time, Scott is willing to spend $60 and is thrilled that the store is selling this box of chocolates for $20. He feels like he’s getting a $40 discount. The same can be said for Diego and Cameron, but to a lesser extent: Diego was willing to pay $45, while Cameron was willing to pay $30. Amanda was only willing to spend $15 and, therefore, will not buy the chocolate.

Figure 1: Individual Consumer Surplus for Boxes of Chocolates

SOURCE: Author’s illustration.

We can draw some conclusions from this basic example. First, we can calculate the total consumer surplus at the $20 market price. In this case, Scott’s surplus of $40 is added to Diego’s $25 and Cameron’s $10 for a total consumer surplus of $75. Second, if we were to add more buyers willing to pay various amounts for the chocolate, this stairstep graph would smooth out and become a standard demand curve showing that the lower the price is for a good, the more people are willing to purchase it. None of this would be traceable if it weren’t for the price being clearly defined for consumers to compare what they’re willing to spend with what they are required to pay.

Price Tags and Producer Surplus

Economist Alfred Marshall, who outlined the concept of consumer surplus, also outlined a similar analysis done from a seller’s standpoint. Suppliers are willing to sell at different prices as well, which we examine in Figure 2 below. Andria was willing to sell her chocolates for only $5 but sees that the store has set the price at $20. She feels like she’s gaining an extra $15 for each box she sells. This is called producer surplus. Katrina was willing to sell her chocolates for $10, so she would gain an extra $10 for each box. Kelly is happy to sell her chocolates at $20, but her producer surplus is $0 as the market price is the same threshold at which she is willing to sell. No one will purchase Christian’s chocolates as he is only willing to sell at $30, which is above the market price.

Figure 2: Individual Producer Surplus for Boxes of Chocolates

SOURCE: Author’s illustration.

Adding up Andria’s, Katrina’s, and Kelly’s surpluses, we find that the total producer surplus is $25. If we add more producers selling at various prices, this stairstep graph would also smooth out, this time becoming the supply curve for the total market. As with the demand curve, if the price for an item is not clearly defined, it’s impossible for sellers to calculate any producer surplus. Exchanges will still occur, but analyzing the total market and drawing larger conclusions is difficult. On the other hand, a widely known price will bring market forces into clear view.

Checking Out: Price Tags and Market Consequences

If consumer surplus and producer surplus are combined, their sum is known as total surplus. Figure 3 below shows that if a price for a good maximizes surpluses for all consumers and producers—meaning that every buyer and seller who thinks they are getting a deal participates in the exchange at the market price—it is known as an equilibrium price.

Figure 3: Total Surplus for Boxes of Chocolates

SOURCE: Author’s illustration.

Without a specific price known to both consumer and producer, it is extremely difficult (if not impossible) to draw further conclusions about a market. In Istanbul’s Grand Bazaar, consumers know how much they are willing to pay, and producers know at what price they are willing to sell. But without price transparency, the odds are increased that some exchanges will not take place, as every transaction is the result of an individual negotiation. This inefficiency reduces the number of exchanges that contribute to economic growth, and it potentially prevents some purchases from ever taking place if customers are reluctant to negotiate with a seller over how much to pay.

Conclusion

Despite its relative simplicity, John Wanamaker’s price tag innovation revolutionized the way consumers and producers behave when making purchases and how economists view and explain the world around us. So, the next time you’re in a checkout line confident that you know what you’ll be paying when you arrive at the register, spare a thought for the little price tag that has made a big difference.