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Dr. Smith
In order to understand consumer surplus, let’s begin by looking at the market for compact
discs. The market demand and supply functions are given by the equations below:
Qd = 1000 − 50 P
Qs = −200 + 50 P
Let’s graph these equations, but first let’s turn the demand and supply functions into
inverse demand and inverse supply functions.
20
S
12
400 1000 Q
You will notice that I have labeled the market equilibrium – the equilibrium price is $12
and the equilibrium quantity is 400.
In equilibrium, set Qd = Qs
Now, let’s turn our attention to the concept of consumer surplus. We will begin with the
definition:
To get a firm grasp of what consumer surplus is all about, let’s return to our CD example.
If we use our demand function, then we may determine what a consumer would have
been willing to pay for the first CD sold in the market - $19.98. Where does this figure
come from?
P = 20 − 501 Q
Therefore, for the first CD a consumer is willing to pay $19.98. What did that consumer
actually have to pay? The equilibrium price of $12! Therefore, the consumer who was
willing to pay $19.98 is able to enjoy a “surplus” of $7.98 (the difference between what
they were willing to pay $19.98, and what they had to pay $12.)
The important thing to notice is that there will be surplus of this sort associated with
every CD sold except the very last one! (The 400th.) How can we calculate the total
consumer surplus that is being enjoyed by consumers in the compact disc market?
20
S
12
400 1000 Q
I have colored in two areas on our graph. Let’s think about what these areas represent.
First, let’s begin with the red rectangle. The red rectangle has height of 12 (the
equilibrium price) and width of 400 (the equilibrium quantity). Therefore, the area of the
red rectangle represents the total amount consumers had to spend to buy 400 compact
discs.
Remember, though, that the consumers would have been willing to pay more than the red
rectangle in order to acquire the 400 compact discs. How much would consumers have
been willing to pay? The demand curve gives us our answer. At any quantity we choose
the demand curve tells us how much consumers would have paid in order to acquire that
CD. Therefore, the total willingness to pay for compact discs is given by the area
underneath the demand curve. In our example, consumers’ total willingness to pay is
represented by the red rectangle added to the blue triangle.
So, this brings us back to our key question. How can we calculate the total consumer
surplus in this market? We simply need to perform the following calculation:
Consumer surplus = (Consumers’ total willingness to pay for Q* units; the blue triangle
added to the red rectangle) – (What consumers actually had to pay for Q* units; the red
rectangle)
Specifically,
CS = 12 ⋅ (400) ⋅ 8 = 1600
Graphically,
20
S
12
4
D
400 1000 Q
So, what do our colored areas represent in this instance? The purple trapezoid and the
green triangle should be familiar to us, for when we add them together we have a
rectangle of height 12 and base 400. In other words, the purple trapezoid and the green
triangle represent the total amount the producers received from selling 400 compact
discs. However, we will find that they would have been willing to accept less than this in
order to provide the 400 discs. How much would they have been willing to accept?
For the first compact disc a firm would have been willing to accept $4.02 – let’s check to
see where that figure is coming from:
P = 4 + 501 Q
Producer surplus = (What producers received for Q* units; the purple trapezoid added
to the green triangle) – (What producers would have been willing to accept for Q* units;
the purple trapezoid)
PS = (Purple Trapezoid + Green Triangle) – Purple Trapezoid = Green Triangle
Specifically,
PS = 12 ⋅ (400) ⋅ 8 = 1600
To see how we use these concepts take a look at the problems on Problem Set 2!