Both parties will gain from a trade if the value to the buyer exceeds the price the seller is asking, and the price the seller receives exceeds the value he has for the good/service.
Returning to our beautifully hand-drawn graph (yup, we at a Force For Good are on the cutting edge of 19th Century technology), we can graphically show these gains from trade thus:
For every consumer price willing to be paid (as shown by the demand curve) that exceeds the price sellers are willing to receive (the supply curve) a trade is expected to occur, and the gains from these trades will be the difference between the price the consumer pays and the difference the producer receives. The sum of all these gains is the green triangle above, what we in economics call total surplus.* We see here what we have logically derived: trade is beneficial.
Up until now, we have been talking solely about interpersonal trade, one person trading with another. To derive a market demand curve, that is all people trading in this market, we simply sum all the individual demand curves together (∑D) and all the supply curves together (∑S). The logic is as follows: if one person is willing to buy one apple at $5, and a second person is willing to also buy just one apple at $5, then the market demand for apples at $5 is 2 apples. Same with suppliers. This summating function allows us to expand our specific conclusions derived from the past few posts to a more general claim: it doesn’t matter if the trade is inter-personal, inter-town, inter-county, or inter-state (note that externalities do not change this analysis. See the Coase Theorem). The conclusions are also true with the inter-national level, a topic which we will expand upon in the next blog post.
* Note that we could separate this out between consumer surplus and producer surplus, but for our purposes here, such a distinction does not matter. It does not change the analysis one wit.