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Consumer surplus is when a consumer’s willingness to pay for a good or service is higher than the price that they actually paid. So let’s say that you play the guitar and you find this guitar on eBay that you really really want and you’d be willing to pay up to $800 for this guitar. But you end up in the auction actually getting the guitar the actual price that you pay is $550. So you would have paid up to $800 but it only got bid up to $550. You were the winning bidder and so you see here that your willingness to pay exceeds the price that you actually paid. If we were to subtract $550 from $800 we would get $250. So we would say that you have $250 of surplus.
Now the producer surplus, we’re just thinking about the cost of producing the good deducted from the amount that the producer receives. So let’s say that there’s a producer that makes drum kits right so they make drum kits for people to play the drums and stuff for a band. It costs them $300 to produce a drum kit but they sell the drum kit for $700. So now we see that there is a minimum cost that they needed to break even would have been $300 but they actually get $700 for the drum kit. We would say that the difference there which you can think about is profit or however you want that is producer surplus of $400 and so we can actually calculate the consumer surplus and the producer surplus for all the consumers and all the producers in the market.
In that example, I just gave the consumer surplus of one person. We just about you buying a guitar on eBay but we could think about all the different consumers and producers in the market and we could calculate the surplus for both of those groups and then if we were to add the consumer surplus and producer surplus for everybody then we would have the total surplus of basically that’s produced by having transactions occur in the market. Let me give you an example, now again we’re thinking about the whole market, so we’ve got our demand curve, and let’s just say that we’re talking about Surfboards. So let’s say that this is the market for surfboards and we’re not just talking about one person’s demand for surfboards we’re talking about everybody. So this demand curve tells us all the different amounts that would be demanded at different prices in the market.
Then we’ve got our supply curve that’s the amount that the producers of surfboards are willing to supply at different quantities for different prices. So we’ve got our equilibrium and I’ve got a article on supply and demand if this is new to you but when the supply curve and the demand curve intersect that point is our equilibrium.
So in a free market, we have an equilibrium price of $800 and our equilibrium quantity is 100,000 products. We can see that at this equilibrium price of $800, there were some people in the market who would have been willing to pay more than $800 to get a surfboard for example right here at point “A”
at this point let’s just say that would be a price of $1,000. So there are people who would have paid $1,000 but they got the surfboard for the equilibrium price of $800. Each of them got $200 of surplus and so how do we calculate all of the consumer surpluses? Because some people would have been willing to pay $1100 some people would have been willing to pay $850 etc but no one would have been willing to pay $1200 or more because we see at a price of $1200 the quantity demanded is zero. Nobody’s demanding anything so all this area here
This area here is our consumer surplus that triangle is our consumer surplus. So it’s the area below the demand curve but it’s above the price so this whole triangle is our consumer surplus.
Mathematical Calculation of Consumer Surplus
We can take the area of that, we can actually calculate the number because if we’re thinking about the area of a triangle so we’d say is our consumer surplus it’s going to be equal to 1/2 multiplied by the base multiplied by the height of the triangle. Our base is going to be that distance between 0 to 100,00 and that’s a (100,000 – 0) which is 100,000. So we’re gonna have 1/2 times 100,000 times the height and the height is just going to be 1200 minus 800 which is 400. if you multiply all this out you get $20,000,000 is the consumer surplus.
Let’s think about it with the producers, this supply curve we can think of as the minimum supply price. That’s the minimum amount at each point given a certain amount, there’s a certain quantity was the minimum price that the suppliers would demand. So here we want all the points below the price of $800 below that price but above the supply curve, this whole area is going to be our producer surplus.
Mathematical Calculation of Producer Surplus
We can calculate the producer surplus because again in this case it’s just a triangle. Throatily in this case just 1/2 multiplied by the base multiplied by the height of the triangle. So we’re gonna have 1/2 times the base which is again 100,000 times the difference between the height here of this triangle is 800 minus 400 which is again $400.
In this case, it just so happens to work out that the producer surplus and the consumer surplus are actually exactly the same $20,000,000. but we’re gonna talk about all kinds of instances where the producer surplus and the consumer surplus are not the same we’re gonna have things like a quota on imports or a tariff or different things that they’re gonna change where we have maybe transfer some of the consumer surpluses is actually transferred to producers and then we’re gonna have some cases where we lose some value and nobody gets it, well I have a situation where nobody’s getting some section and we’ll call that a deadweight loss.
So basically if we want to add up the value being created by this market we can add the consumer surplus and the producer surplus together we can add these two amounts and that’s 40 million dollars. So 40 million dollars is the total surplus. Now, why is this relevant? Why do we even care what the surplus is? Because we can think about things like a tariff we can think about different things that a government can do and then we can say how does it affect this surplus. If there’s some kind of government acts like a price ceiling or something like that that comes in and takes away some of that surplus then we can think about we’ve lost value as a society and then we can also think about who are the winners and losers of a policy and we’ll talk about all that a lot more in the articales to come.