How to Calculate Consumer Surplus: 12 Steps

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How to Calculate Consumer Surplus: 12 Steps
How to Calculate Consumer Surplus: 12 Steps

Video: How to Calculate Consumer Surplus: 12 Steps

Video: How to Calculate Consumer Surplus: 12 Steps
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The term “consumer surplus” is used by economists to represent the difference between the amount of money consumers are willing to pay for a good or service and the actual market price. Specifically, consumer surplus happens when consumers are willing to pay more for a good or service than they actually pay. While this sounds like a complicated calculation, doing it is actually quite simple once you know how to assemble the equation.

Steps

Method 1 of 2: Defining Key Concepts and Terms

Calculate Consumer Surplus Step 1
Calculate Consumer Surplus Step 1

Step 1. Understand the Law of Demand

Most people have heard the phrase “supply and demand” in reference to the mysterious forces governing market economies, but many do not understand the real implications of these concepts. “Demand” refers to the desire there is to have an existing good or service on the market. In general, if all other factors are equal, demand for a product will fall as its price increases.

For example, let's say a company is going to launch a new television model. The more it charges for this new model, the fewer televisions it can expect to sell. This is because consumers have limited amounts of money to use, and by paying more for a television, they can forgo spending on other items that would bring more benefits (food, fuel, rent, etc.)

Calculate Consumer Surplus Step 2
Calculate Consumer Surplus Step 2

Step 2. Understand the Law of Offer

On the other hand, the law of supply dictates that products and services that are offered at high prices will be provided in high demand. In other words, people who sell want to make as much income as possible by selling a lot of expensive products, so if a certain type of product or service is very profitable, vendors will rush to produce that product or service.

For example, let's say that before Mother's Day, tulips are very expensive. In response to this event, farmers who have the capacity to grow tulips will invest resources in this activity, producing them as much as possible to take advantage of the situation

Calculate Consumer Surplus Step 3
Calculate Consumer Surplus Step 3

Step 3. Understand how supply and demand are graphically represented

A very common way for economists to express the relationship between supply and demand is through a two-dimensional x/y graph. Typically, in this case, the x axis is called Q, or the quantity of goods on the market, and the y axis is called P, or the price of those goods. Demand is expressed as a curve running from the top left to the bottom right corner of the chart and supply as a curve going from the bottom left to the top right corner.

The intersection of the supply and demand curves represents the point at which the market is in equilibrium-in other words, the point at which producers supply exactly the amount of goods and services demanded by consumers

Calculate Consumer Surplus Step 4
Calculate Consumer Surplus Step 4

Step 4. Understand the concept of marginal utility

Marginal utility represents the increase in satisfaction obtained by a consumer when obtaining an additional unit of a given good or service. In general terms, the marginal utility of goods and services is subject to a reduction in profits - in other words, each additional unit purchased offers less benefit to the consumer. Eventually, the marginal utility of the good or service decreases to the point where it is “no longer worth it” to buy an additional unit.

For example, let's say a consumer is very hungry. She goes to a restaurant and orders a hamburger for R$15. Then she still feels a little hungry and orders another hamburger for R$15. The marginal utility of the second hamburger is a little less than that of the first, however that it offers less satisfaction in terms of hunger relief in terms of cost than the former. The consumer decides not to buy a third hamburger because it is full and, therefore, it can be said that a third party would have virtually no marginal use for her

Calculate Consumer Surplus Step 5
Calculate Consumer Surplus Step 5

Step 5. Understand consumer surplus

Consumer surplus is broadly defined as the difference between the “total value” or “total value received” of a product by consumers and the actual price that is paid for it. In other words, if consumers pay less for a product than it is worth to them, the consumer surplus represents that “economy”.

As a simplified example, let's say a consumer is in the market looking for a used car. He allowed himself to use R$40,000. If he buys a car with everything he wants for R$24,000, we can say that there was a consumer surplus of R$16,000. In other words, the car was worth R$40,000 to him, but he ended up getting the car and a surplus of R$16,000 to use as he liked on other things

Method 2 of 2: Calculating Consumer Surplus from Supply and Demand Curves

Calculate Consumer Surplus Step 6
Calculate Consumer Surplus Step 6

Step 1. Create an x/y graph to compare price and quantity

As noted earlier, economists use graphs to compare the relationship between supply and demand in the market. Since consumer surplus is calculated based on this relationship, we will use this type of chart in our calculations.

  • As described previously, define the y axis as P (price) and the x axis as Q (quantity of goods).
  • The different intervals present on the axes correspond to different respective values - price intervals on the price axis and quantity of goods on the quantity axis.
Calculate Consumer Surplus Step 7
Calculate Consumer Surplus Step 7

Step 2. Place the supply and demand curves for the good or service in question

Supply and demand curves - especially in early examples of consumer surplus - are often represented as linear equations (straight lines on the graph). Your consumer surplus problem may already have the supply and demand curves graphed, or in another case you may have to enter them.

  • As in the previous explanation of the curves in the graph, the demand curve goes down from the top left corner and the supply curve goes up from the bottom left.
  • The supply and demand curves for any good or service will always be different, but they must faithfully reflect the relationship between demand (in terms of how much money can be spent by potential consumers) and supply (in terms of how many goods have been purchased).
Calculate Consumer Surplus Step 8
Calculate Consumer Surplus Step 8

Step 3. Find the balance point

As discussed earlier, the balance in the relationship between supply and demand is at the point on the graph where both curves intersect. For example, let's say that this break-even point is equal to 15 units with a price of R$20 per unit.

Calculate Consumer Surplus Step 9
Calculate Consumer Surplus Step 9

Step 4. Draw a horizontal line on the price axis, at the height of the break-even point

Now that you know the breakeven point, draw a horizontal line from that point, perpendicular to the price axis. In our example, we know that the point will cross the price axis at R$20.

The triangular area between the horizontal line, the vertical line of the price axis and the point where both curves intersect represents consumer surplus

Calculate Consumer Surplus Step 10
Calculate Consumer Surplus Step 10

Step 5. Use the correct equation

Since the consumer surplus triangle is a right triangle (the equilibrium point intersects on the price axis at a 90° angle) and the "area" of this triangle is what you want to calculate, you need to know how calculate the area of the right triangle. The equation for doing this is ½ (base × height) or (base × height) / 2.

Calculate Consumer Surplus Step 11
Calculate Consumer Surplus Step 11

Step 6. Enter the corresponding numbers

Now that you know the equation and the numbers, you're ready to enter them.

  • In our example, the base of the triangle is the quantity demanded at the equilibrium point, that is, 15.
  • To get the height of the triangle in our example, we need to take the equilibrium price (BRL 20) and subtract it from the price at which the demand curve intersects with the price axis (let's say it's BRL 48 in our example). If 48 - 20 = 28, we have a height equal to 28.
Calculate Consumer Surplus Step 12
Calculate Consumer Surplus Step 12

Step 7. Calculate consumer surplus

With the numbers entered into the equation, you're ready to solve it. In the present example, EC = ½ (60 × 28) = ½ × 420 = R$210.

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