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 P_E and the quantity Q_E. As we know, the demand curve indicates consumers’ willingness to pay. In the chart, the amount that consumers actually are paying is P_E — the equilibrium market price for oranges. Therefore, for each transaction that occurs up to Q_E, consumer surplus is achieved in an amount equal to the distance between the demand curve and P_E. 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

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 (Q_E). 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 (P_E).

“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 (Q_E) and the height being the equilibrium price (P_E).

“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.