Consumer Surplus Definition
Consumer Surplus is the difference between the actual price that the customers pay for a product & the maximum price that they are ready to pay (for a single unit). You can calculate Consumer Surplus by using the formula as = Maximum Price to be paid willingly – Actual Paid Price
Consumer Surplus Formula
There are two ways to calculate Consumer Surplus
#1 – Basic Formula
Consumer Surplus Formula = Maximum Price Willing To Pay – Actual Price
- Find the maximum price that the consumer is willing to pay.
- The price they actually pay for a product.
- Difference between (1) and (2).
#2 – Using Consumer Surplus Graph
Another way to calculate consumer surplus is through demand and supply graph. Let’s understand this with the help of the diagram below.
The above consumer surplus graph represents the demand curve (red line) and the supply curve (green line) with “quantity” across the x-axis and “price” along the y-axis. 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. is a downward-sloping curve, which means that as the price of the product increases, its demand falls (other factors remaining constant). On the other hand, 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. is an upward sloping curve which means as the price of a product increases, it supplies also increases (other factors remaining constant).
As per 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. and supply, the intersection (point S) where both the curves meet is known as equilibrium or market price. The market price is the price the consumer is willing to pay for a given quantity of goods or services.
As per the graph, area of ∆RPS = 1/2 * base * height
which is = 1/2 * PS *RP or 1/2 * OQ * RP
How to Calculate Consumer Surplus?
You can calculate consumer surplus using these three simple steps:
- Firstly, assess the utility of the product for the consumer based on which the highest price that the consumer is willing to pay can be arrived at.
- Now, figure out the actual price of the product in the market.
- Finally, the consumer surplus is arrived at by deducting the value derived in Step 2 from the value in Step 1 as shown below.
The following four steps help in the calculation of the consumer surplus using graph (which is more popularly used):
- Step 1: Firstly, draw the Supply and Demand curves with quantity on the abscissa and price on the ordinate.
- Step 2: Now, locate the market price which is the equilibrium price. According to the law of supply and demand, the market price is the point of intersection between the supply and the demand curveThe Demand 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..
- Step 3: Now, draw a horizontal line between the market equilibrium price and the ordinate.
- Step 4: Finally, calculate the area of the upper triangle (ΔRPS in the above diagram). Consequently, calculation of consumer surplus can be done by multiplying the base (RP) and the height (PS) and then dividing by 2.
Consumer Surplus Examples
Let us take the example of a single customer and a single product. So, let us assume that a customer decides to buy a mobile with a 16GB RAM and a 5.5″ screen and is willing to pay up to $1,200 for that. Now, while browsing through various electronics stores, the customer discovers a store that offers all the criteria exactly at $900.
- Maximum price willing to pay = $1,200
- Actual price = $900
- Consequently, using the first formula we get, Consumer Surplus = $1,200 – $900
- = $300
Let us take another example wherein a customer is willing to pay $20 for the packed food item and this is the highest price among the customers. In fact, the majority of the customers are willing to pay only $10, which is eventually the market price (demand and 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. meet). Now at $10, the total food packets demanded is 30 (equilibrium demand).
- Demand quantity at equilibrium = 30 units
- Maximum price willing to pay – Market price = $20 – $10 = $10
- Consequently, using the extended formula we get,
- Consumer Surplus = ½ * 30 * $10 = $150
Now, let us take an example of consumer surplus with the demand function represented as QD = -0.08x + 80 and the supply function represented as QS=0.08x where x is the quantity demanded in kg.
In the below-given template is the data used for the calculation.
From the above data, we have collected the data required for the calculation.
In the below given excel template
So the calculation of Consumer Surplus will be-
Relevance and Uses
- It is very important to have a clear understanding of the Consumer surplus concept. It can help take business decisions associated with the price-output setting, value pricing, and price discriminationPrice DiscriminationPrice Discrimination refers to the charging of different prices for the same type of products in different markets. It is a microeconomic pricing strategy, where the pricing mechanism depends upon the monopoly of the company, preferences of the customers, uniqueness of the product and the willingness of the people to pay differently. under the purview of various marketing strategies.
- It has to be accepted that there is a trade-off between consumer surplus and revenue generated. If the emphasis is laid on increasing revenue through an increase in the product price, then the surplus will deteriorate as a result.
- The aforementioned scenario may result in higher income but accompanied by a relative weakening of the firm’s position among competitors with identical products. As such, one has to be very cautious while fixing the price in order to ensure that the consumer surplus is not impacted severely.
This has been a guide to what is Consumer Surplus and its definition. Here we discuss the formula to calculate it along with examples. You can learn more about Excel Modeling from the following articles –