When customers feel like they are getting the most benefits from buying a certain product while paying the least, they are likely to buy that product again in the future. And many businesses rely on this for their profits. So, to determine the right pricing for their product, companies calculate something called consumer surplus.
Without having a decent idea of how much your customers are willing to pay for your product you will most likely over price or under price your product. And that can lead to either low sales or low profits, which I think you can already assume. So, every business owner is required to know how to calculate consumer surplus for a successful business.
This article will teach you the definition of consumer surplus and show you the formula for calculating it. The article will also provide you a guide explaining the steps for calculating consumer surplus. All these will help you to grasp this concept clearly.
Consumer Surplus Formula
The consumer surplus (CS) formula can be derived by deducting the retail price of a service or product from the price that its customers are willing to pay.
The mathematical representation of the consumer surplus formula is given below,
CS = (Maximum Price Willing To Pay) – (Actual Retail Price)
The formula for consumer surplus can be further extended for a whole economy i.e., multiple buyers. Take a look at the following picture.
In the above illustration, the area of ΔADC represents the consumer surplus. This area is bounded by the Y-axis i.e. price, the demand curve, and the horizontal line drawn in the illustration to find out the demand at equilibrium.
In the illustration, point C and point A represent the retail price of the product and the maximum price that its consumers are willing to pay respectively. Point E represents the demand at equilibrium. Using the illustration, the consumer surplus formula can be represented as follows,
CS = 12Area of ΔADC
= 12× AC × DC
= 12× AC × OE [Here, OE || DC]
Consumer Surplus Definition
The term “Consumer Surplus” refers to the difference between the maximum price that consumers are willing to pay and the price they actually pay.
In economics, consumer surplus is a metric that measures the excess benefits that buyers receive when their willingness to pay for a good or service is greater than its retail price. The concept of “Consumer Surplus” comes from the theory of marginal utility.
This theory implies the satisfaction that a customer gets by consuming one or multiple units of a service or product. The level of happiness/satisfaction differs from one consumer to another. And this happens due to differences in people’s personal preferences.
Consumer surplus measures the benefit that buyers get as they are paying less for a service or a product than what they were normally ready to pay. And according to the law of diminishing marginal utility, a consumer is less willing to pay more for a good or service that he or she consumes frequently.
How To Calculate Consumer Surplus
Take a look at the following step-by-step guide to understand how to calculate consumer surplus.
Method 1
Use the following steps to calculate the consumer surplus using the first formula mentioned above:
Step 1: First of all, find out the retail price of a service or product or service whose consumer surplus you want to calculate.
Step 2: Next, analyze data or surveys to determine the maximum amount that customers are willing to pay for that particular product or service.
Step 3: Now, just put the values that were determined in “Step 1” and “Step 2” into the first formula mentioned above to calculate the consumer surplus for that product.
Method 2
Use the following steps to calculate consumer surplus using the second formula mentioned above in this article:
Step 1: First of all, draw the “Supply and Demand” curves with the price on the vertical axis and quantity on the horizontal axis.
Step 2: Next, identify the market price at the equilibrium point. This point is located at the intersection of the supply and demand curves.
Step 3: In this step, draw a line that is parallel to the horizontal axis between the market price at equilibrium and the vertical axis.
Step 4: Lastly, compute the upper triangle area (i.e. are of ΔADC in the above illustration). This will give you the consumer surplus for that particular economy.
Practical Examples
Take a look at the following examples to clearly grasp how to calculate consumer surplus.
Example 1
Let’s start with the problem of a single product and a single buyer. Consider Alex wants to purchase the RTX 3060 Ti graphics card that was released just a few days ago. He is willing to pay as much as $2,000 to purchase this graphics card.
But due to huge demand, he was unable to find it anywhere in the market. But after a lot of research and patience, he was able to procure one from a computer hardware store at a cost of $1,800. Calculate the consumer surplus for Alex.
Here, the maximum price that Alex is willing to pay is $2,000 and the retail price of the RTX 3060 Ti graphics card was $1,800/.
So, in Alex’s case, the consumer surplus is going to be,
CS = (Maximum Price Willing To Pay) – (Actual Retail Price)
= (2,000) – ($1,800)
= $200
Therefore, Alex spent $200 less as a consumer surplus than what he was willing to pay which he can use to buy other services or products.
Example 2
Let’s assume the supply function is represented as S = 0.02x and the demand function is expressed as D = -0.02x + 15. Here, the quantity of demand is in meters and represented by x.
Use the above information and find out the consumer surplus in this example.
The following table contains all the data that is needed to calculate consumer surplus for this example.
Now, use the supply and demand data from the table and plot it in a graph.
From that graph, identify the market price, maximum price customers are willing to pay, and the demand for that product at the equilibrium point.
In this example, the maximum price that customers are willing to pay is $15, the market price of the product is $7.50 and the quantity of the demand is around 370 units.
So, the consumer surplus is going to be,
CS = 12Area of ΔADC
= 12× AC × DC
= 12× AC × OE [Here, OE || DC]
From the above picture, AC = ($15 – $7.50) = $7.50
OE = DC = 370 Units
So,
CS = 12× AC × OE
= 12× $7.50 × 370
= $1,387.50
Therefore, the consumer surplus in this example is $1,387.50.
Use and Importance of Consumer Surplus
First of all, the concept of “Consumer Surplus” can help businesses and companies with major decisions regarding different marketing strategies such as value pricing, price-output setting, and price discrimination.
Revenue and consumer surplus are opposite to each other. From the supply and demand curves, you can see that increasing the product price will result in an increase in revenue. But at the same time, the consumer surplus will deteriorate because of that.
This is very useful because such actions can increase a company’s revenue, but it might cause the company to lose its market share to its competitors. So, companies have to be careful while fixing their product price in order to avoid any sort of negative impact on the consumer surplus.
Conclusion
This article contains a brief guide on how to calculate consumer surplus along with examples. Hopefully, the things I’ve covered in this article were enough to clear all your doubts. Have a great day. And thanks a lot for stopping by!
