What is Consumer Surplus?
Consumer surplus is a widely used economic term and explains the difference between the price of the product that a consumer is willing to pay and the price that he actually pays. In other words, a consumer has a surplus when he pays less price for a good or service that he consumes and can also use that surplus to additionally consume more goods/services. This concept is used widely by governments for social welfare and producers/manufacturers to determine the price of the product.
This is based on the concept of marginal utility. Marginal Utility is the additional satisfaction that a consumer gains for consuming extra units of goods or services. As the consumer buys a higher quantity of goods or services, the less they are willing to pay due to a decrease in the additional benefit they receive. This is also known as the diminishing law of marginal utility.
How to Calculate Consumer Surplus?
#1 – Using Consumer Surplus Formula
Consumer Surplus Formula = Maximum Price Willing – Actual Price Paid
- To 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 curve 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 curve 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 demand 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 consumer surplus graph, area of ∆RPS = 1/2 * base * height
which is = 1/2 * PS *RP or 1/2 * OQ * RP
Consumer Surplus Examples
Let us now look at some of the consumer surplus examples –
Consumers are willing to pay $1,500 for a Smart Television and the price they actually pay is $1,200. Hence, surplus would be $1,500-$1,200 = $300.
Consider an example where for a particular product, the market price is $ 18. The demand corresponding to this price is 20 units. However, because of its utility, customers are ready to pay as high as $ 30 for this commodity. Below is the consumer surplus graph.
The highlighted area in the graph signifies Consumer Surplus. Here surplus can be deduced by calculating the area under the highlighted part in the graph. Using basic knowledge of geometry, the shaded area can be calculated as:
Consumer Surplus Formula = (1/2) * base * height = (1/2) * 20 * (30-18) = $ 120
In the table below, we can see the demand and supply of products for a given price.
The equilibrium point is at 10 units at the price of $14, which is the point where the price is equal for both demand and supply.
Hence, surplus would be = 1/2 * $14 * 10 = $70
- It is a great way for producers/manufacturers to fix the price of their goods/services that they are offering to consumers. It helps them understand how much the consumer is willing to pay for their product and how much surplus is left for consumers.
- From a macroeconomic point of view, consumer surplus study helps the government decide how much tax should be imposed on the extra income that the consumer saves. It also helps the government understand the effect of inflation on consumer surplus as higher the rate of inflation will force the consumer to either spend less or save less.
- It is difficult to calculate utility. Utility depends upon person to person and varies differently across different categories of product and personal choice. Where there is huge competition in the market for the same product with different specifications and features, calculating utility becomes difficult. However, in a market of the monopolist, he can easily calculate utility for his product, which is next to impossible today considering there is so much competition.
- The law of demand and supply is based on two important factors- price and quantity. It may not be possible to obtain realistic data of prices that the consumer is paying or willing to pay.
- In today’s world, relying only on these factors only is not possible as there are other microeconomic (personal choice, taste, etc.) and macroeconomic (government policy, trade policy) factors to be considered also.
- The income of consumers varies vastly. It’s not possible to calculate consumer surplus in different circumstances.
Even though this concept is widely criticized by modern economist, due to the factors it considers, it’s still used as a study by producers to keep in mind how and when to change the price of the product and for governments to understand how the economy is moving towards growth and development. A developed economy will have commodity available at a lower price so consumers enjoy higher surplus whereas, in case of developing/underdeveloped countries, commodities are available at a higher price which results in low surplus.
This has been a guide to What is Consumer Surplus and its Definition. Here we discuss the formulas to calculate consumer surplus along with examples, advantages, and disadvantages. You can learn more about investment banking from the following articles –