#Business and #Economics ~ Consumer Surplus Explained

30 Oct

As always, this lesson is not intended to be professional advice. This is simply lesson material for ESL students in an introductory Economics and Finance class. Posted here for their use or for helping other students.

This is not intended to be an advanced, in-depth economic analysis of consumer surplus. However, in teaching the concept to my students, I discovered that most websites and teaching materials did not explain the material very well.  They all wanted to start with Consumer Surplus is X – Y .  . . and oh, by the way, it’s also the area of a triangle! 😀

Which sucks, because it does not explain why it is the area of the triangle.

So for all the beginning 101 ESL students, I hope this helps explain it!

Part #1 ~ Vocabulary

• Buyer (n.) ~ A person who exchanges their money in return for a product. Someone who purchases the product. 买方 – Mǎifāng
• Competition (n.) ~ A situation where two or more people are struggling to claim the same resource.  In economics and business, sellers of substitutes are competing for the same buyers. 竞争 – Jìngzhēng
• Consumer Surplus (n.) ~ The difference between the price the buyer would have paid for a product and the price the buyer did pay for the product.   消费者过剩 – Xiāofèi zhě guòshèng
• Demand Curve (n.) ~ A line showing the relationship between the number of products people want to buy and the price. The demand curve shows how many products are demanded at each price. 需求曲线 – Xūqiú qūxiàn
• Discount (n.) ~ How much the seller has decreased the price from its original amount. Tommy changed the price of his bicycles from \$400 to \$300. This is a 25% discount. 折扣 – Zhékòu
• Discount (v.) ~ To lower the price. When the seller lowers the price of a product in order to increase demand, they discount the price. 贱卖 – jiàn mài
• Economic Value (n.) ~ The maximum price that a buyer would have paid for a product. The demand curve shows the economic value for each quantity. 经济价值 – Jīngjì jiàzhí
• Law of Demand (n.) ~ The rule in economics that says when the price of a product goes up, the quantity demanded will go down. When the price of a product goes down, the quantity demanded will go up.  需求法则 -Xūqiú fǎzé
• Market Demand (n.) ~ The total number of products that all buyers require.  Usually shown on a Market Demand Curve demonstrating the relationship between the total quantity demanded and the price.  市场需求- Shìchǎng xūqiú
• Market Price (n.) ~ The price of a product when it is sold / The price a buyer pays for a product and a seller gets for a product. 市场价格 – Shìchǎng jiàgé
• Perfect Competition Market (n) ~ A market or industry where there are many buyers and many sellers. All are competing with each other for the best price in a market where there are many substitutes and the products are pretty similar. Companies in these markets have low market power and are usually price-taking. 完美的竞争 – Wánměi de jìngzhēng
• Seller (n.) ~ Someone who offers a product in exchange for money. The person or company presenting a produce on the market for purchase.  卖家 – Màijiā
• Total Consumer Surplus (n.) ~ Draw a triangle using the Demand Curve and the Market Price.  Total Consumer Surplus is the area of that triangle.  It is the total savings of all the buyers on the market. See Consumer Surplus.    消费者剩余总额 – Xiāofèi zhě shèngyú zǒng’é

Part #2 ~ What is Consumer Surplus?

The perfect competition 完美的竞争market is a beautiful creature full of amazing trends 趋势and patterns!  In a perfect competition market, buyers and sellers can sometimes trade a product at a better price than they expected (预期).

Example #1: Timmy is interested in buying a soda (Coca Cola).  Because Timmy is really thirsty, he takes 3¥ and goes to the store to look for a soda.  Although Timmy is willing to pay 3¥ for the soda, he is very happy! He finds a discount 贱卖 where sodas are only 2.80¥ at Walmart.   This means Timmy saved 0.20¥ for his drink! 😊

We call that 0.20¥ a Consumer Surplus (消费者过剩)!  If a buyer pays a price lower than the maximum he was willing to pay, he has a consumer surplus.  By definition: Consumer Surplus is the difference between what the buyer would have paid and what the buyer did pay.

Example #2:  Tara wants to buy a bicycle. She goes to the store and sees that a bicycle is 400¥.  That seems like a good price. She goes home and works and works and works and works. One month later, she has 400¥. She goes to the store again, but now the bicycle is on sale! Discount! The new price is 350¥! 😊 Yay!  She has a Consumer Surplus of 50¥!

Notice: Both the buyer and the seller think the Consumer Surplus is important. For the buyer, the more money they save, the happier they are. The more they save, the more they are willing to buy.  Remember, this market has competition竞争 because there are many buyers and many sellers.  So, if Company A offers the buyer a bigger consumer surplus than Company B—the buyer will shop at Company A.  This is good for the buyer, but bad for Company B.  So Company B will be watching—if Company A has a sale and gives the buyer big savings, Company B will also probably offer a sale in the future also.  We see this all the time—the same product is on sale at 5 different stores.

Part #3 ~ How to Find Consumer Surplus for One Product?

Consumer Surplus = Economic Value – Market Price

Oh dear. . . . new words.

Let’s start at the beginning.  Economic Value (. 经济价值) is the maximum price the buyer would have paid.  For Timmy, that price for one soda was 3¥.  For Tara, that price for one bicycle was 400¥.

But in economics 经济学, where do we find this number?  How can you know what the maximum price is that a buyer would have paid?  How do you know how much the buyer was willing to give to the seller?

THE DEMAND CURVE!

The demand curve 需求曲线 is a line that tells us how many products a buyer is willing to buy at a certain price.  It is the price per product

Example: In the picture below:

If the price is \$3.00, Timmy will buy one soda (that is the maximum price Timmy is willing to pay for Soda #1).  Economic Value for Soda #1 = \$3.00

If the price is \$2.50, Timmy will buy two sodas (that is the maximum price Timmy is willing to pay for Soda #2). Economic Value for Soda #2 = \$2.50

If the price is \$1.00, Timmy will buy 5 sodas (that is the maximum price Timmy is willing to pay for Soda #5).  Economic Value for Soda #5 = \$1.00

This line shows us an important economic 经济学 rule called the Law of Demand.  This rule says that if the Quantity Demanded is going up, then the price must go down. Each extra soda that Timmy buys is worth a little bit less to him. ☹

So, what is Market Price  (价格)? Market Price is the actual price for the product that the buyer paid.  For Timmy, this price was 2.80¥ for one soda. For Tara, the Market Price was 350¥.

In the graph above:

Economic Value for Soda #1 = \$3.00

Market Price for Soda #1 = \$1.00

Consumer Surplus for Soda #1 = \$3.00 – \$1.00 = \$2.00

Economic Value for Soda #2 = \$2.50

Market Price for Soda #2 = \$1.00

Consumer Surplus for Soda #2 = \$2.50 – \$1.00 = \$1.50

Notice! Important! It is true that if Timmy buys more soda, will save a larger total amount of money.  If he buys only one soda, he just saved \$2.00. But if he bought 2 sodas, he would have saved (\$2.00 +\$1.50 = \$3.50). This is why your parents always buy more if something is on sale at the store.  But the savings for each extra soda goes down, down, down. He saves a little bit less for each extra soda he buys.

Here’s the problem — most companies do not just have one buyer (Timmy).  Most companies sell thousands of products to thousands of buyers. Some sell millions of products a day!

This is why we don’t always use Economic Value – Market Price. If you only had two products, that might be pretty easy.  But if you have 500,000 products it gets harder and harder to do EV – MP for every single one.

So we have something special called Total Consumer Surplus (消费者剩余总额).  The total consumer surplus is the TOTAL savings for all the buyers.

To find Total Consumer Surplus, we need to start with a new line called the Market Demand Curve (市场需求).

Let’s say that we have 3 airplane companies: United Airlines, China Eastern Airlines, and Korean Air. They all want to buy Soda for their airplanes.

 United Airlines China Eastern Korean Air \$0.00 500 550 425 \$0.50 400 450 325 \$1.00 300 350 225 \$1.50 200 250 125 \$2.00 100 150 25 \$2.50 0 50 0 \$3.00 0 0 0

Now we could try to write three demand curves and do a lot of math.

But much easier is making a new demand curve based on the total number of products all three companies are willing to buy.

 \$0.00 1475 \$0.50 1175 \$1.00 875 \$1.50 575 \$2.00 275 \$2.50 50 \$3.00 0

The Market Demand Curve would look like this:

Now, we have a “Demand Curve” to work with for Total Consumer Surplus. So let’s start!

Step 1: Market Price.

I say that Market Price was \$1.00!  Draw a line showing how many products were purchased at one dollar on our graph.

From the purple line, we know that when the price was \$1.00 the demand for sodas was 875 bottles for all three companies.

Step 2: Let’s cover up everything after 875 bottles with Yellow Marker . . . . nobody bought those so we won’t count bottles 876 through 1475.  For Consumer Surplus, you can forget about those bottles.

Step 3: Now, the Market Price was \$1.00 per bottle.  This means they paid \$875 to the company.  Let’s fill in everything below the purple line with Purple Marker to show how much money the buyers lost.

Step 4:    Okay. . . . now we can do Consumer Surplus the very, very, very long way.  This means drawing a line from the Economic Value to to the Market Price for every single one of the 875 bottles of soda that we sold.

Soda #1 = Economic Value1 – Market Price1
Soda #2 = Economic Value1 – Market Price1
Soda #3 = Economic Value1 – Market Price1
Soda #4 = Economic Value1 – Market Price1
Soda #5 = Economic Value1 – Market Price1

Notice how we just keep coloring in that triangle more and more? If we did all 875 lines, the entire triangle would be colored!

This is why, when we do Total Consumer Surplus, we say you should find the AREA OF A TRIANGLE (一个三角形的区域) instead of adding together all the Economic Value – Market Price that you would have to do.

The total amount of money that the airlines saved was about \$875.   So Total Consumer Surplus for the market was \$875!