Chapter 1 provided an informal introduction to a procedure for measuring changes in social welfare. It was suggested that increases or decreases in private sector welfare could be identified with the net gains or losses resulting from changes in consumer and producer surplus; on diagrams, these surpluses were represented by areas below the demand curve and above the supply curve. This approach is in many ways an over-simplification. In order to see why changes in consumer and producer surplus may provide only an approximate measure of welfare change it is necessary to take a closer look at some of the underlying microeconomic theory relating to the behaviour of individual consumers and producers. Much of this basic microeconomic theory will be familiar to readers; nevertheless, we include a short summary of the material that will be needed not just for a more detailed discussion of consumer and producer surplus, but also for use in the general equilibrium analysis introduced in chapter 3 and used throughout the book.

The next two sections are concerned with the theory of the optimising consumer: Marshallian and Hicksian demand curves are introduced in section 2.1; section 2.2 considers alternative measures of consumer surplus and examines the effect of price and income changes on the demand for commodities. Sections 2.3 and 2.4 deal, respectively, with the assumptions underlying the behaviour of the firm in the long and the short run, and the latter section concludes with a more detailed look at the meaning of producer surplus.