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Calculating Consumer and Producer Surplus

The following is an adapted excerpt from my book Microeconomics Made Simple: Basic Microeconomic Principles Explained in 100 Pages or Less.

“Consumer surplus” refers to the value that consumers derive from purchasing a good. For example, if you would be willing to spend $10 on a good, but you are able to purchase it for just $7, your consumer surplus from the transaction is $3. You’re getting $3 more value from the good than it cost you.

We can use a chart of supply and demand to show consumer surplus in a market.

EXAMPLE: The following chart shows the perfectly competitive market for oranges. The market is in equilibrium at the price PE and the quantity QE. As we know, the demand curve indicates consumers’ willingness to pay. In the chart, the amount that consumers actually are paying is PE — the equilibrium market price for oranges. Therefore, for each transaction that occurs up to QE, consumer surplus is achieved in an amount equal to the distance between the demand curve and PE. As a result, the shaded area in the chart indicates the total consumer surplus achieved in the orange market.

Consumer and Producer Surplus in Perfect Competition

Consumer and Producer Surplus

To calculate the total consumer surplus achieved in the market, we would want to calculate the area of the shaded grey triangle. If you think back to geometry class, you will recall that the formula for area of a triangle is ½ x base x height. In this case, the base of the triangle is the equilibrium quantity (QE). And the height of the triangle is the amount by which the y-intercept of the demand curve (i.e., the price at which quantity demanded is zero) exceeds the equilibrium price (PE).

“Producer surplus” refers to the value that producers derive from transactions. For example, if a producer would be willing to sell a good for $4, but he is able to sell it for $10, he achieves producer surplus of $6.

Like consumer surplus, producer surplus can also be shown via a chart of supply and demand. This time, however, the surplus from each transaction is represented by the distance between the supply curve (which denotes the lowest price suppliers would be willing to accept) and the market price. The total producer surplus achieved in the orange market would be represented by the dotted area in the chart.

The area of the dotted triangle (representing producer surplus) is calculated as ½ x base x height, with the base of the triangle being the equilibrium quantity (QE) and the height being the equilibrium price (PE).

“Total surplus” refers to the sum of consumer surplus and producer surplus. Total surplus is maximized in perfect competition because free-market equilibrium is reached. That is, if a quantity less than the free-market equilibrium quantity were transacted, total surplus would be less, because there would be beneficial transactions that are failing to occur (i.e., transactions where consumers’ willingness to pay is greater than the lowest price suppliers are willing to accept). And if a quantity greater than the free-market equilibrium quantity were transacted, total surplus would be less, because transactions that cost more to producers than consumers would be willing to pay would occur.

Want to Learn More about Microeconomics? Pick Up a Copy of the Book:

Microeconomics Made Simple: Basic Microeconomic Principles Explained in 100 Pages or Less
Topics Covered in the Book:

Marginal Revenue for a Monopoly

The following is an adapted excerpt from my book Microeconomics Made Simple: Basic Microeconomic Principles Explained in 100 Pages or Less.

The term “marginal revenue” refers to how much additional revenue a firm would earn from one additional unit of output.

EXAMPLE: Marty owns a small-scale ski park in a location far from any other site suitable for skiing (so, in Marty’s local market, his business is a monopoly). Because Marty has no competition, he can charge whatever price he wants for admission to his park, and he can test different prices to see which is the most profitable.

Calculating Marginal Revenue

Assuming that a monopoly must charge each customer the same price for its good, the monopoly faces a downward sloping marginal revenue curve — meaning that each additional unit the firm sells brings in less revenue than the unit before. The reason for this declining marginal revenue is that the firm must reduce the price it charges for its product if it wants to sell more units. And that new lower price would apply to all units sold — including all the units sold to buyers who would have been willing to pay a higher price.

EXAMPLE: The following figure shows the demand curve and the resulting marginal revenue curve for Marty’s ski park monopoly.

Demand and Marginal Revenue Curves for Marty’s Ski Park (Monopoly)

MRinMonopoly

If he charges $50 for a day pass, Marty can sell 40 passes per day — for a total daily revenue of $2,000. Marty’s marginal revenue for the first 40 passes is $50 per pass.

If Marty reduces the price to $40, he can sell 80 passes per day — for a total daily revenue of $3,200. The marginal revenue for the 40 additional passes sold is $1,200 (i.e., $3,200 minus $2,000), or $30 per pass.

If Marty reduces the price further to $30, he can sell 120 passes each day — for a total daily revenue of $3,600. The marginal revenue for the additional 40 passes sold is $400 (i.e., $3,600 minus $3,200), or just $10 per pass.

Marty faces declining marginal revenue (i.e., each additional pass sold brings in less additional revenue than the previous pass) because when he reduces his price to sell more passes, he reduces the price that every visitor to the park pays — even those visitors who would have paid a higher price.

Note: As you can see in the above chart, for a monopoly, if the demand curve is a straight line, the marginal revenue curve will also be a straight line, with exactly twice the slope of the demand curve.

Maximizing Profit by Producing at MC = MR

Just like firms in other types of markets, monopolies choose to produce each unit for which marginal revenue exceeds marginal cost. That is, they produce up to the point at which marginal revenue is equal to marginal cost because this is the point at which the firm’s profit is maximized.

Want to Learn More about Microeconomics? Pick Up a Copy of the Book:

Microeconomics Made Simple: Basic Microeconomic Principles Explained in 100 Pages or Less
Topics Covered in the Book:

The 4 Factors of Production

The following is an adapted excerpt from my book Microeconomics Made Simple: Basic Microeconomic Principles Explained in 100 Pages or Less.

In economics, “factors of production” are the inputs used to create finished goods (i.e., the actual products we buy). In other words, these are the scarce resources that we, as a society, must choose how to allocate. Ideally, we would do so in a way that maximizes our wellbeing. Traditionally, the factors of production are:

  • Land (which includes land itself as well as other natural resources and phenomena — water, forests, fossil fuels, weather, etc.),
  • Labor (the human work necessary to produce and deliver goods), and
  • Capital (manmade goods used to produce other goods — factories, machinery, highways, electrical grid, etc.).

More recently, human capital — the knowledge and skills that make workers productive — has been considered a fourth factor of production.

How should a society allocate its factors of production? One desirable criterion is to use all resources to their fullest capacity or, to put it another way, to use the fewest possible resources for any given level of output (e.g., if a set of kitchen cabinets only requires 100 nails, a carpenter shouldn’t pound in more). “Productive efficiency” is the term used to describe a situation in which this is achieved.

Another desirable criterion is that the factors of production are all used to make the quantities and types of goods that society most highly values. For example, if a society values the arts more highly than sports, it should invest more resources in the former than in the latter. “Allocative efficiency” is the term used to describe a situation in which productive resources are being used in their most valuable way.

Want to Learn More about Microeconomics? Pick Up a Copy of the Book:

Microeconomics Made Simple: Basic Microeconomic Principles Explained in 100 Pages or Less
Topics Covered in the Book:
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