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Consumer Surplus

Updated on April 18, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

Consumer Surplus Definition

Consumer surplus (CS) refers to the difference between the highest rate that consumers are ready to pay for the product and the real market rate they paid. Moreover, calculating consumer surplus demonstrates the net benefit gained through product consumption. Additionally, it lies between the demand curve and equilibrium price on the supply and demand curve.

Consumer Surplus Definition

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Also known as “social surplus,” it defines the benefit experienced by consumers after purchasing something at a much-decreased rate than predicted. Companies in monopolistic markets with sufficient market power can diminish social surplus, execute price discriminationPrice DiscriminationPrice discrimination is a pricing strategy whereby firms sell the same products or services at different prices in different markets. It is the means adopted to ensure winning competition by letting consumers purchase goods at a lenient rate.read more, and relish profit optimization.

Key Takeaways

  • Consumer surplus is the differentiation between the maximum product price consumers are willing to spend and the actual price they pay.
  • The consumer surplus formula = Highest product price consumers can pay – Market price
  • It is the best way to compute the actual worth of an item or utility, and monopolies usually employ it to decide the product’s retail price.
  • Consumer surplus and producer surplus are two distinct categories of economic surplus. While higher market price decreases the former, it boosts the latter considerably.

Consumer Surplus Explained

Consumer surplus is an outstanding technique for calculating the worth of a commodity or service, for example, buying a supposedly $500 airplane ticket for $300. Furthermore, monopolies often use the approach to determine the product’s retail price. It is established on the law of diminishing marginal utilityLaw Of Diminishing Marginal UtilityThe law of diminishing marginal utility states that the amount of satisfaction provided by consuming every additional unit of goods decreases as we increase that goods consumption. Marginal utility is the change in the contentment derived from consuming an extra unit of goods.read more devised by the English economist, Alfred Marshall.

According to the hypothesis, the product consumption frequency is inversely related to the consumers’ readiness to invest more in other units. Moreover, Marshall asserts that the more of an item the consumers purchase, the less eager they are to spend more on each of its extra units.

This happens due to the product-derived diminishing marginal utility. The usefulness obtained from the subsequent product consumption is lesser than the primary product utilization.

Meanwhile, let’s check the social surplus theory presumptions:

  • Replacements are unavailable.
  • The utility is a quantifiable matter.
  • The marginal utility of cash is uniform.
  • Consumers’ preferences, likings, and earnings are fixed.
  • The marginal utility of two similar products is independent of each other.
  • Product utilization frequency is inversely proportionate to the marginal utility of each additional unit.

Please note that consumer surplus and producer surplus are two sides of the same coin with different calculation techniques, definitions, and examples. Both demonstrate the economic assessment of consumer and producer benefits, respectively.

The former implies the distinction between the highest rate consumers are keen to pay for the product. However, the latter denotes the difference between the actual price obtained by the producer and the minimum acceptable price.

Let’s demonstrate both producer surplus and consumer surplus examples. Consumer Surplus entails buying an airplane ticket for $300 that you were ready to buy for $500. On the flip side, product surplus displays a scenario like purchasing a villa for $10,000, which is more than the expected price of $5000.

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Consumer Surplus Graph

Here is the graph used for calculating consumer surplus:

Consumer Surplus Graph

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The part beneath the equilibrium price and above the supply curveSupply CurveSupply curve represents the relationship between quantity and price of a product which the supplier is willing to supply at a given point of time. It is an upward sloping curve where the price of the product is represented along the y-axis and quantity on the x-axis.read more (green line) is labeled as product surplus (PS). The part above the equilibrium price and underneath the demand curveDemand CurveDemand Curve is a graphical representation of the relationship between the prices of goods and demand quantity and is usually inversely proportionate. That means higher the price, lower the demand. It determines the law of demand i.e. as the price increases, demand decreases keeping all other things equal.read more (red line) is known as consumer surplus.

The demand curve is generally downward-sloping as the product price conversely impacts its demand. Contradictorily, the supply curve is broadly upward sloping since the product price is directly related to its demand. Moreover, the intersection point of the demand and supply curve is called the equilibrium or market priceMarket PriceMarket price refers to the current price prevailing in the market at which goods, services, or assets are purchased or sold. The price point at which the supply of a commodity matches its demand in the market becomes its market price.read more.

While the equilibrium market price is on the y-axis, market quantity is on the x-axis. This is because it strictly follows both the law of demandLaw Of DemandThe Law of Demand is an economic concept that states that the prices of goods or services and the quantity demanded are inversely related when all other factors remain constant. In other words, when the price of a product rises, its demand falls, and when its price falls, its demand rises in the market.read more and the law of supplyLaw Of SupplyThe law of supply in economics suggests that with other factors remaining constant, if the price of a commodity increases, its market supply also goes up and vice-versa.read more.

Furthermore, the CS is zero when the product demand is perfectly elastic. Consequently, a slight price alteration extremely affects the product demand. This is because consumers are ready to match its cost but not pay more for the same.

Contrarily, the CS is infinite in the case of perfectly inelastic demand because the rate variations of basic necessities do not influence their demand. Therefore, consumers are ready to invest more in the product. This prompts vendorsVendorsA vendor refers to an individual or an entity that sells products and services to businesses or consumers. It receives payments in exchange for making items available to end-users. They constitute an integral part of the supply chain management for providing raw materials to manufacturers and finished goods to customers.read more for price increment and transforms CS into PS.

Moreover, the consumer surplus formula is,

Consumer Surplus Formula = Highest product price consumers are ready to spend – Market price

Examples

Now, here are consumer surplus examples:

Example #1

Suppose that Fanny wants to purchase a fully-automatic top load 7kg washing machine with 700 rpm, temperature control feature, and an auto detergent dispenser. He is also ready to spend a maximum of $800. Nonetheless, he discovers a reputed electronic store offering the desired product at just $500.

Now, let’s apply the formula for calculating consumer surplus:

CS = Highest product price consumers are ready to invest – Market price

      = $800-$500

      = $300

Example #2

Google’s pricing power is more extensive due to the absence of any natural limit to the market. Thus, it can charge a rate for its services close to the maximum cost its customers can bear, leading to the limitation of social surplus. Its paying consumers like advertisers do not enjoy social surplus, and so we, as the non-paying users, also carry this loss due to an eventual hike in advertising rates.

Pros of Consumer Surplus

The advantages of CS include:

  1. Growth expansion for monopolists and businessmen
  2. Insightful comparison of benefits of diverse products or facilities
  3. Assists in public financePublic FinancePublic finance is the management of the country's public funds through revenue, expenditure, and reserves, and it generally includes the management of tax collection, expenditures, the annual national budget, deficits, and surpluses.read more
  4. Extremely useful in welfare economics
  5. Determining the subsidiesSubsidiesA subsidy in economics refers to direct or indirect financial assistance from the government to an individual, household, business, or institution to promote social and economic policies.read more
  6. Surges foreign trade of useful items
  7. Helps justify the launch of a new product

Frequently Asked Questions (FAQs)

How To Find Consumer Surplus?

The easiest method to calculate consumer surplus is by subtracting the actual product retail price from the maximum amount consumers are willing to spend on the product. In other words, the consumer surplus formula is,
CS = Maximum price that consumers are ready to pay – Real market price

Can Consumer Surplus Be Negative?

Yes, consumer surplus can be negative if the product’s market price is higher than the maximum product price that consumers are willing to pay. But, contrarily, it is positive when the market price is less than what consumers are willing to spend on it.

What’s Consumer Surplus?

Consumer surplus denotes the difference between the maximum amount consumers are ready to pay for an item and the actual market price they paid. It is a consumer welfare measure used to express the benefit of acquiring something at a price which is less than expected. It is also called social surplus and is based on the theory of diminishing marginal utility.

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Comments

  1. DEREUNA HILTON says

    I have learnt and known the definition of consumer surplus