Calculate Consumer Surplus
Consumer surplus is a term used by economists to describe the difference between the amount of money consumers are willing to pay for a good or service and its actual market price. Specifically, a consumer surplus occurs when consumers are willing to pay more for a good or service than they currently pay. Though it sounds like a tricky calculation, calculating consumer surplus is actually a fairly easy equation once you know what to plug into it.
Contents
Steps
Defining Key Concepts and Terms
- Understand the law of demand. Most people have heard the phrase "supply and demand" used in reference to the mysterious forces governing market economies, but many don't understand these concepts' full implications. "Demand" refers to the desire for a good or service in the marketplace. Generally, if all other factors are equal, demand for a product will fall as its price increases.
- For example, let's say that a company is about to release a new model of television. The more they charge for this new model, the fewer televisions they can expect to sell overall. This is because consumers have limited amounts of money to spend and, by paying for a more expensive television, they may have to forego spending money on other things which can give them some greater benefit (groceries, gasoline, mortgage, etc.).
- Understand the law of supply. Conversely, the law of supply dictates that products and services that demand a high price will be supplied at a high rate. Essentially, people who sell things want to make as much revenue as possible by selling lots of expensive products, so, if a certain type of product or service is very lucrative, producers will rush to produce that product or service.
- For example, let's say that right before Mother's Day, tulips become very expensive. In response to this, the farmers who have the ability to produce tulips will pour resources into this activity, generating as many tulips as possible to take advantage of the high-price situation.
- Understand how supply and demand are represented graphically. One very common way that economists express the relationship between supply and demand is via 2-dimensional x/y graph. Usually, in this case, the x axis is set as Q, the quantity of goods in the marketplace, and the y axis is set as P, the price of the goods. Demand is expressed as a curve sloping from the top left to the bottom right of the graph and supply is expressed as a curve sloping from the bottom left to the top right.
- The intersection of the supply and demand curves is the point at which the market is at equilibrium—in other words, the point at which producers are producing precisely as many goods and services as consumers demand.
- Understand marginal utility. Marginal utility is the increase in satisfaction a consumer gets from consuming one additional unit of a good or service. In very general terms, the marginal utility of goods and services is subject to diminishing returns—in other words, each additional unit purchased provides less and less benefit to the consumer. Eventually, the marginal utility of the good or service diminishes to the point that it's not "worth it" for the consumer to purchase an additional unit.
- For example, let's say that a consumer is very hungry. She goes to a restaurant and orders a hamburger for $5. After this hamburger, she's still a little hungry, so she orders another hamburger for $5. The marginal utility of this second hamburger is slightly less than that of the first since it provides less satisfaction in terms of relief from hunger for its cost than the first hamburger does. The consumer decides not to buy a third hamburger because she's full, and thus, the third hamburger has virtually no marginal utility for her.
- Understand consumer surplus. Consumer surplus is broadly defined as the difference between an item's "total value" or "total value received" to consumers and the actual price that they pay for it. In other words, if consumers pay less for a product than what it's worth to them, consumer surplus represents their “savings”.
- As a simplified example, let's say that a consumer is in the market for a used car. He has given himself $10,000 to spend. If he buys a car with everything he wants for $6,000, we can say that he has a consumer surplus of $4,000. In other words, the car was worth $10,000 to him, but he ended up with the car and a surplus of $4,000 to spend as he pleases on other things.
Calculating Consumer Surplus from Demand and Supply Curves
- Create an x/y graph to compare price and quantity. As noted above, economists use graphs to compare the relationship between supply and demand in the marketplace. Since consumer surplus is calculated based on this relationship, we'll use this type of graph in our calculation.
- As noted above, set the y axis as P (price) and the x axis as Q (quantity of goods).
- The different intervals along the axes will correspond to different respective values—price intervals for the price axis and quantities of goods for the quantity axis.
- Place supply and demand curves for the good or service being sold. Supply and demand curves—especially in early examples of consumer surplus—are usually represented as linear equations (straight lines on the graph). Your consumer surplus problem may already have the supply and demand curves plotted, or you may have to plot them.
- As with the explanation of the curves on a graph earlier, the demand curve will slope down starting from the top left, and the supply curve will slope up starting from the bottom left.
- The supply and demand curves for any good or service will be different, but should accurately reflect the relationship between the demand (in terms of the amount of money consumers would potentially spend) and the supply (in terms of the amount of goods purchased).
- Find the point of equilibrium. As discussed earlier, equilibrium in the supply and demand relationship is the point on the graph where the two curves intersect one another. For example, let’s say the point of equilibrium is at 15 units with a price point of $5/unit.
- Draw a horizontal line on the price axis at the point of equilibrium. Now that you know the point of equilibrium, draw a horizontal line starting from that point that intersects perpendicular to the price axis. For our example, we know that the point is going to intersect the price axis at $5.
- The triangular area between this horizontal line, the vertical line of the price axis, and where the demand curve intersects both is the area corresponding to consumer surplus.
- Use the correct equation. Since the triangle corresponding to consumer surplus is a right triangle (the equilibrium point intersects the price axis at a 90° angle) and the ‘’area’’ of that triangle is what you want to calculate, you must know how to calculate the area of a right triangle. The equation for it is 1/2(base x height) or (base x height)/2.
- Plug in the corresponding numbers. Now that you know the equation and the numbers, you’re ready to plug them in.
- For our example, the base of the triangle is the quantity demanded at the point of equilibrium, which is 15.
- To get the height of the triangle for our example, we must take the equilibrium price point ($5) and subtract it from the price point at which the demand curve intersects the price axis (let’s say $12 for your example. 12 - 5 = 7, so we would use a height of 7.
- Calculate the consumer surplus. With the numbers plugged into the equation, you’re ready to solve. With the running example, CS = 1/2(15 x 7) = 1/2 x 105 = $52.50.
Tips
- This number corresponds to the total consumer surplus because the consumer surplus for one individual consumer is simply the consumer’s marginal benefit or the difference between what he or she would have paid versus the amount actually paid.
