GT

 Concept  Note  ®  
ECO2013  -­‐  Spring  2010  
 

Consumer  Surplus  
Several   times   throughout   the   course,   we’ve   used   demand   curves   to   represent   an  
individual’s  (or  a  market’s)  demand  for  a  specific  good.  The  Law  of  Demand  says  that  as  the  
price  of  a  good  increases,  the  consumer  purchases  less  of  that  good.  But  how  much  worse  
off  is  the  consumer  after  the  price  increase?  Equivalently,  how  much  better  off  would  the  
consumer  be  if  he  could  purchase  the  good  at  a  lower  price?  
To  quantify  this  value,  we  need  to  first  introduce  some  terminology.  Let’s  begin  with  
a   simple   example,   where   a   consumer   buys   a   single   good.   The   consumer   has   a   certain  
reservation   price   relating   to   this   good.   If   the   price   of   the   good   is   above   this   reservation  
price,   the   consumer   is   not   willing   to   buy   the   good;   if   it   is   at   or   below   this   reservation   price,  
the   consumer   is   willing   to   buy   the   good.   We   call   this   reservation   price   the   consumer’s  
willingness  to  pay  for  the  good,  or  the  amount  that  he  values  the  good.  
Often,  consumers  are  able  to  purchase  goods  at  a  price  that  is  below  their  maximum  
willingness   to   pay.   For   example,   imagine   a   consumer   values   a   certain   car   at   a   price   of  
$20,000,  but  the  car  is  currently  listed  at  a  price  of  $17,000.  Because  the  consumer  is  able  
to  pay  $17,000  for  a  car  that  he  values  at  $20,000,  he  would  be  $3,000  better  off.  This  dollar  
measure  of  how  much  better  off  a  consumer  is  because  he  gets  to  purchase  a  good  at  the  
prevailing  market  price  is  called  his  consumer  surplus.  
The   calculation   of   consumer   surplus   is   simple   when   a   consumer   has   a   choice  
between  buying  either  one  unit  or  zero  units.  When  a  consumer  has  the  option  of  buying  
more  than  one  unit,  the  story  becomes  a  bit  more  complex.  This  is  because  he  may  value  
additional   units   of   the   good   differently   than   the   first.   For   a   quick   example   of   how   this  
works,   suppose   that   you   value   one   Krispy   Kreme   donut   at   $3.00,   and   pay   the   $2.00   market  
price  for  it.  After  you  eat  that  donut,  you  may  want  another  one,  but  not  quite  as  much  as  
you   wanted   the   first,   since   you’ve   already   had   one.   So,   let’s   say   you   value   the   second   donut  
at  $2.00.  You  buy  the  second  donut  at  the  market  price  of  $2.00.  Now,  the  third  donut  has  a  
value   to   you   of   $1.50,   so   you   don’t   buy   a   third,   because   the   market   price   is   above   your  
willingness   to   pay.   In   all,   you’ve   consumed   two   donuts,   paid   $4.00   for   them,   but   your  
willingness   to   pay   for   the   two   donuts   was   $3.00   +   $2.00   =   $5.00.   Your   consumer   surplus   in  
this  example  is  $1.00.  
In  the  previous  example,  we  had  to  know  the  consumer’s  willingness  to  pay  for  each  
additional   unit   consumed.   We   call   this   value   the   marginal   willingness   to   pay.   Since  
demand  curves  tell  us  how  many  units  of  a  good  a  consumer  is  willing  to  buy  at  any  given  
price,   a   consumer’s   demand   curve   is   nothing   more   than   a   locus   of   points   that   tells   us   his  
marginal  willingness  to  pay  for  different  units  of  the  good.  The  consumer  will  continue  to  
buy  additional  units  of  a  good  as  long  as  his  marginal  willingness  to  pay  for  the  next  unit  
exceeds  the  market  price.  
 
 
 
 
 GT  Concept  Note  ®  
ECO2013  -­‐  Spring  2010  
 
Here,   we   see   a   consumer’s   demand   curve   (marginal  
willingness  to  pay)  for  a  good.  The  points  show  his  quantity  
demanded   for   certain   prices.   Suppose   that   price   is   actually  
$4.   For   the   first   unit,   we   can   see   that   his   maximum  
willingness  to  pay  is  $7;  as  he  only  pays  $4,  the  going  market  
rate,  he  has  a  surplus  of  $3  on  that  unit,  shown  by  the  light  
rectangle  in  the  graph.  Similarly,  when  paying  $4  per  unit,  he  
has   a   surplus   of   6-­‐4   =   $2   on   the   second   unit,   and   5-­‐4   =   $1   on  
the   third   unit.   The   following   table   summarizes   this  
information.  
  Marginal   Total   Total  Willingness  to  
Q  
  Willingness  to  Pay   Surplus   Pay  
  1   7   3   7  
2   6   3+2=5   7+6=13  
  3   5   3+2+1=6   7+6+5=18  
  4   4   3+2+1+0=6   7+6+5+4=22  
So,  the  consumer’s  total  willingness  to  pay  for  all  four  units  is  $22.  By  paying  $4  per  unit,  he  
pays  a  total  $16,  and  thus  has  a  consumer  surplus  of  $6.  
If   we   have   a   linear   demand   curve,   we   don’t   have   to   add   up   the   surplus   for   each   unit  
to  find  total  consumer  surplus.  Instead,  we  can  just  find  the  area  of  the  triangle  under  the  
demand  curve  and  above  price  –  this  will  give  us  total  consumer  surplus.  
 

Example:  Consumer  Surplus  

Suppose  market  demand  is  given  by  the  equation   P = 10 − .004Q  and  the  current  price  
is  $2.  Find  the  market  consumer  surplus.  
Solution:  The  easiest  way  to  find  market  CS  is  to  graph  the  curve.  At  a  price  of  $2,  the  
market  quantity  sold  is  2,000  units:  

 
Consumer  surplus  is  just  the  area  of  the  indicated  triangle.  The  base  of  the  triangle  is  
2,000  and  the  height  is   10 − 2 = 6 ,  so  consumer  surplus  is  
 GT  Concept  Note  ®  
ECO2013  -­‐  Spring  2010  
 
2, 000(8)
  CS = = 8, 000  
2
 

Producer  Surplus  
We   now   discuss   how   much   better   off   firms   are   as   a   result   of   the   ability   to   sell   at   the  
market   price.   On   the   consumer   side,   we   defined   willingness   to   pay   as   the   consumer’s  
reservation  price.  This  reservation  price  was  based  on  the  consumer’s  preferences  –  how  
much  he  “valued”  the  good.  A  firm  has  a  reservation  price  at  which  they  are  willing  to  sell  
their   goods.   This   price   is   based   on   the   cost   to   the   firm   of   producing   the   units.   The   firm’s  
cost   of   producing   the   next   unit   is   called   the   marginal   cost.   Since   supply   curves   tell   us   how  
many   units   of   a   good   a   firm   is   willing   to   sell   at   any   given   price,   a   firm’s   supply   curve   is  
nothing  more  than  a  locus  of  points  that  tells  us  its  marginal  cost  for  different  units  of  the  
good.  The  firm  will  continue  to  sell  additional  units  of  a  good  as  long  as  its  marginal  cost  to  
produce  the  next  unit  is  below  the  market  price;  that  is,  as  long  as  selling  the  next  unit  is  
profitable  for  the  firm.  
Producer   surplus   is   a   dollar   value   that   measures   how   much   better   off   a   firm   is  
because   it   gets   to   sell   its   product   at   the   prevailing   market   price.   It   is   the   analogue   of  
consumer   surplus,   but   for   firms.   If   we   have   a   linear   supply   curve,   finding   producer   surplus  
is  as  easy  as  finding  consumer  surplus:  just  find  the  area  of  the  triangle  above  the  supply  
curve,  and  below  price.  
 

Example:  Producer  Surplus  

Suppose  market  supply  is  given  by  the  equation   P = 1 + .002Q  and  the  current  price  is  
$2.  Find  the  market  producer  surplus.  
Solution:  The  easiest  way  to  find  market  PS  is  to  graph  the  curve.  At  a  price  of  $2,  the  
market  quantity  sold  is  500  units:  

 
Producer  surplus  is  just  the  area  of  the  indicated  triangle.  The  base  of  the  triangle  is  500  
and  the  height  is   2 − 1 = 1 ,  so  producer  surplus  is  
 GT  Concept  Note  ®  
ECO2013  -­‐  Spring  2010  
 
500(1)
  PS = = 250  
2
 

Deadweight  Loss  
We   have   seen   that   both   producers   and   consumers   benefit   from   being   able   to   buy  
and   sell   at   prevailing   market   prices.   Society’s   total   surplus   is   the   sum   of   the   consumer  
surplus  and  the  producer  surplus  in  a  market.  
When   markets   are   not   in   equilibrium,   total   surplus   is   not   being   maximized.   The  
difference   between   the   maximum   total   surplus   and   actual   total   surplus   is   called  
deadweight   loss.   It   is   value   that   producers   or   consumers   aren’t   receiving   because   of   some  
outside  interference,  such  as  a  tax  or  subsidy.  It  is  easiest  to  explain  through  an  example.  
Suppose   demand   for   corn   is   P D = 20 − .001Q D   and   supply   of   corn   is  
P S = 10 + .004Q S .  (Notice  that  our  prices  have  superscripts  on  them  now,  to  distinguish  the  
price   that   consumers   pay   for   a   product   from   the   price   that   firms   receive.   We   will   do   this  
whenever   dealing   with   a   tax   or   a   subsidy,   as   these   two   prices   usually   differ).   Setting  
P D = P S  and   Q D = Q S  to  find  equilibrium  quantity,  we  get  
20 − .001Q = 10 + .004Q
10 = .005Q  
Q = 2000
Price  is  
P D = 20 − .001(2000)
   
P D = 18
So   equilibrium   price   is   $18   and   the   market   quantity   transacted   is   2,000   units.   Now,  
suppose   that   the   government   imposes   a   tax   on   the   market   for   corn   of   $1   per   unit.   This  
means  that  every  time  a  consumer  buys  a  unit  of  corn,  $1  of  the  price  he  pays  goes  to  the  
government;  in  other  words,  the  difference  between  the  price  the  consumer  pays  (PD)  and  
the  price  the  producer  receives  (PS)  is  $1:  
  P D = P S + 1  
It   is   important   to   understand   that   this   doesn’t   mean   that   the   firm   is   paying   the   entire   $1  
tax.  As  we  discussed  earlier,  the  supply  curve  is  determined  by  the  firm’s  marginal  cost  of  
producing  an  additional  unit.  Since  they  now  have  to  send  $1  for  each  unit  they  sell  to  the  
government,  it  is  as  if  their  MC  has  increased,  shifting  the  supply  curve  up.  This  will  result  
in   a   higher   price   for   the   consumer,   which   means   that   ultimately   some   of   the   tax   burden  
falls  on  him  as  well.  How  much  is  dependent  on  the  elasticities  of  supply  and  demand.  
To   find   out   the   new   quantity   transacted   after   the   tax,   we   simply   substitute   the  
equation   above   into   either   demand   or   supply,   and   solve   the   new   system   of   equations.   Note  
 GT  Concept  Note  ®  
ECO2013  -­‐  Spring  2010  
 
that   we   still   have   one   quantity   ( Q S = Q D = Q ),   because   the   higher   price   to   the   consumer  
means  the  short  side  of  the  market  is  the  demand  curve:  
P D = 20 − .001Q (demand curve)
P S + 1 = 20 − .001Q (substituting P D = P S + 1)
P S = 19 − .001Q (demand curve after substitution)
P S = 10 + .004Q (supply curve)  

0 = 9 − .005Q (subtracting the two equations)

Q = 1800
So   1,800   units   are   transacted   after   the   tax.   This   seems   reasonable,   as   the   tax   effectively  
makes  the  price  higher,  which  means  consumers  will  demand  less  than  the  original  2,000  
units.  To  find  the  price  the  consumer  pays  and  the  price  the  firm  receives  after  paying  the  
tax,  use  the  original  supply  and  demand  equations:  
P D = 20 − .001(1800)
P D = $18.20
   
P S = 10 + .004(1800)
P S = $17.20
We   see   that   indeed   the   difference   in   prices   is   $1.   What   is   the   impact   of   the   tax   on   total  
surplus?  Let’s  look  at  some  graphs  to  summarize  what  we  know  so  far.  

 
The  left  graph  shows  the  equilibrium  price  and  quantity,  and  the  total  surplus  (consumer  +  
producer)   as   a   result.   The   right   graph   shows   the   effect   of   the   tax.   The   upward   shift   in  
supply   to   S   +   tax   represents   the   effect   to   the   firm’s   MC   as   a   consequence   of   the   tax.   The  
price  that  consumers  pay  (18.20)  and  that  firms  receive  (17.20)  is  different  by  $1,  the  value  
of  the  tax.  
 GT  Concept  Note  ®  
ECO2013  -­‐  Spring  2010  
 
How   do   we   analyze   the   change   in   total  
surplus  (and  thus  the  deadweight  loss)  that  occurs  
because   of   the   tax?   We   can   see   from   the   above  
graphs   that   both   consumer   surplus   and   producer  
surplus   is   less   than   it   was.   However,   because   the  
tax   revenue   of   $1   per   unit   is   going   to   the  
government,  we  must  include  that  in  how  well  off  
society  is  on  the  whole  (total  surplus).  What  is  the  
total  tax  revenue?  For  each  of  the  1800  units  sold,  
$1  goes  to  the  government;  in  other  words,  a  total  
of   $1 × 1800 = $1, 800   goes   to   the   government   as  
tax   revenue.   This   is   indicated   by   the   red   square  
labeled  “Tax  Rev”  in  the  graph  to  the  right.  
What   of   the   last   triangle   of   surplus   that   was   lost   because   of   the   tax?   This   is   the  
deadweight   loss,   shown   by   the   black   shaded   triangle   in   the   graph   labeled   “DWL”.   The  
deadweight   loss   results   from   value-­‐added   units   that   aren’t   being   consumed.   In   our  
example,   we   can   see   that   there   are   200   more   units   in   this   market   that   aren’t   being  
consumed  whose  benefit  to  consumers  is  greater  than  their  cost  of  production  (based  on  
the  demand  curve  for  those  units  being  above  the  supply  curve).  In  the  absence  of  the  tax,  
these   units   would   be   consumed   and   would   add   value   to   society;   because   of   the   tax,   the  
value  simply  disappears.  
To  calculate  the  deadweight  loss,  just  find  the  area  of  the  black  triangle.  It  has  a  base  
of   2000 − 1800 = 200  and  a  height  of   18.20 − 17.20 = 1 ,  so  the  total  DWL  is    
1
DWL = (200)(1) = $100  
2
In   short,   if   we   calculated   the   consumer   and   producer   surplus   before   the   tax,   it   would   be  
$100  more  than  the  consumer  surplus,  producer  surplus,  and  tax  revenue  after  the  tax.