Final answer:
Consumer surplus is the difference between what consumers are willing to pay and what they actually pay at the market equilibrium price, while producer surplus is the difference between the market price and what producers would accept. Together they form social surplus, which is maximized at market equilibrium. Option 1 is the correct answer.
Step-by-step explanation:
Consumer surplus is defined as the difference between the maximum amount the consumer is willing to pay for a good or service, based on personal preferences, and the market equilibrium price that is actually paid. This concept captures the extra benefit consumers receive from purchasing a good or service at a lower price than their maximum willingness to pay.
In a market diagram, this is often represented by the area above the equilibrium price and below the demand curve. Producer surplus, on the other hand, is the gap between the market price and the minimum price at which producers are willing to sell, effectively measuring their gain over and above their costs.
When these two surpluses are added together, they constitute the social surplus, representing the overall benefit to society from market transactions. At the equilibrium quantity and price, the total surplus is maximized, indicating an efficient market situation. However, if the market is not at equilibrium, for example due to price controls, this causes a deadweight loss, which is a loss in total surplus and reflects an inefficiency in the market.