This post originally appeared on The Finance Buff and was cited by The Carnival of Personal Finance #206.

What follows is an illustrative sketch of a classical economic welfare analysis using Google Reader as an example. It is intended for an audience with no economics background. At the risk of disappointing readers, I confess that, due to lack of data, I make up all the numbers. However, anyone with better estimates of the components could improve the calculation by following the steps outlined. Those familiar with Google Reader may wish to skip the next paragraph.

Google Reader has enhanced my life, changing how I work and spend leisure time. I would not easily keep up with blogs of interest without Google Reader or something like it. (The blogs to which I subscribe are listed in this spreadsheet.) Google Reader is free, but it provides more than zero dollars worth of value to me. If it were not free I would pay something for the service.

For the sake of argument, let’s say I’d be willing to pay \$100 per year for Google Reader. This represents the gross value of Google Reader to me. Since I actually pay \$0, then the net value I receive from Google Reader is \$100 – \$0 = \$100 per year. This is just like \$100 in my pocket because I’d have paid that amount more for Google Reader than I had to. That \$100 represents my individual annual consumer surplus.

I don’t know how many Google Reader users there are, but let’s say there are 10 million. Suppose the average individual user is like me, with a consumer surplus of \$100 per year. Then the annual total consumer surplus of Google Reader is \$100 x 10 million = \$1 billion per year. That’s a lot of value. Of course, I made the numbers up.

Let’s pretend that ad-based revenue Google imputes to its Reader is, on average, \$11 per user per year. Let’s also assume that the average marginal cost of providing Google Reader to each of the 10 million users is \$1 per user per year. So, Google nets \$11 – \$1 = \$10 per year for an average user and, therefore, \$100 million per year for all users. This \$100 million is the annual total producer surplus associated with Google Reader.

Total surplus is the sum of consumer and producer surplus, and is an economic measure of welfare. In our example total surplus is \$1.1 billion, \$1 billion for consumers and \$100 million for the producer.

Typically an economic welfare analysis of a market includes comparisons of surplus values for different market configurations. Doing so leads to conclusions about which group, consumers or producers, is made better or worse off in one setting versus another. It is possible for both producers and consumers to be made better off (or both worse off) via a structural change in the market. Total surplus is maximized in the circumstance of perfect competition, an ideal situation which is actually quite rare.

As an example, we could consider the RSS aggregator market with and without the participation of Google Reader. The analysis above is almost complete for the market with Google Reader. What it lacks is the consumer (producer) surplus associated with RSS aggregator users (producers) who do not use (supply) Google Reader that can be attributed to its presence in the market. It is plausible that its presence in the market causes other aggregators to be less expensive or of higher quality. Thus, users of other aggregators receive consumer surplus and their producers lose producer surplus due to lower prices and higher marginal cost of higher quality.

A separate analysis is required to compute the surplus of consumers and producers in the RSS aggregator market in the absence of Google Reader. To conduct this analysis, one would need a model that predicts what current Google Reader users would do in this case. If Google Reader left the market, how would aggregator market shares adjust? How many Reader users would forego aggregator use altogether? I’ll leave suggestions of ways of making such predictions to a future post.

One thing the above explicitly illustrates is that both producers and consumers are made economically better off through market transaction. It isn’t just that producers get revenue and consumers get products. Producers earn profit and consumers receive value beyond the sticker price. Since most of us are in the role of consumer frequently but seller hardly ever we tend to begrudge the firm its profit and pay little notice to the additional value beyond price we receive in return. Google Reader is not the only bargain. Given the enjoyment and convenience obtained by the multitude of products we use it’s a wonder how little of that full value we actually pay. The rest is consumer surplus.

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