Understanding Consumer Surplus
Consumer Surplus or Buyer’s Surplus is an economic measurement of the customer’s excess benefit. In an economy, a consumer surplus takes place when the consumer is willing to pay more for a product than its market price. Consumer Surplus is an important study in the subject of Economics. Here, we are going to provide insights on “What is Consumer Surplus?”, the method of calculating the surplus, and other important elements of the topic will be discussed.
What is Consumer Surplus?
Consumers' surplus is a tool for measuring the consumer’s welfare and this surplus is defined as the excess of the social valuation of a product that goes over the price that is being actually paid.
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In the above diagram, graphically, consumer surplus is being measured by the area of a triangle that gets formed below a demand curve (shaded in red color) and above the market price (P1).
Further, we will talk about it in detail in the Consumer Surplus formula.
Consumer Surplus and Producer Surplus
While we discuss the consumer and producer surplus, it is very much important that we also understand some basic concepts that are used by economists to explain the interrelationship between the two.
Both the consumers and producer surplus can be graphically illustrated by either the demand curve or the marginal benefit curve and a supply curve or the marginal cost curve.
So, consumer surplus refers to the monetary gain that is enjoyed when a purchaser buys a product for a lesser value than they normally were willing to pay. On the other hand, producer surplus means the price difference that is there between the lowest cost to supply the market and the actual price which the consumers are willing to pay.
How to Calculate Consumer Surplus?
In order to calculate the consumer surplus, we need to consider the factor of demand and supply. The demand curve is a line of a graph that is utilized in economics, this line shows how many units of a good or service are purchased at different prices. The consumer surplus formula is CS = ½ (base) (height).
Consumer Surplus Graph
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From the above diagram, we will understand Consumer Surplus. In the Price axis, the prices are 70 and 50. In the Quantity axis, the quantity is 40. Demand Curve and Supply are drawn accordingly.
The point where the demand and the supply curve meet are marked as the equilibrium price, that is 50. The area above the supply curve and below the equilibrium price is shaded in blue, in this zone the product surplus (or PS) is achieved. While, the area which lies below the demand curve and above the equilibrium price is shaded in green, this area is called the consumer surplus (or CS).
Thus, taking into consideration the demand and supply curves, the formula for consumer surplus as mentioned previously is Consumer Surplus = ½ (base) (height).
Hence, in our example, CS = ½ (40) (70-50) = 400.
Assumptions of Consumer Surplus
Following are the assumptions of the consumer surplus theory:
The utility is a measured type entity:
The consumer surplus theory explains that the value of utility is to be measured. Under Marshallian economics, utility is expressed as a number. For example, the utility derived from ice cream is 10 units. Thus, this is an assumption that Consumer Surplus consists of this explanation of Utility as well.
No substitutes are available in the explanation:
While understanding the Consumers Surplus there are no available substitutes taken into consideration.
This connotes that the customers’ tastes, preferences, and income will not change in any circumstances.
Marginal utility of money remains constant:
This is another assumption which states that the utility that is being derived from the income of a consumer remains constant. There is no change in the amount of money that a consumer possesses, also the amount of utility that they derive from it is not changed. This factor is important as money cannot be used to measure the utility without the assumption.
Law of diminishing marginal utility:
The law of DMU or Diminishing Marginal Utility is also used here, which states that the more a product or service is consumed, the lower be the marginal utility which is derived from consuming each and extra of that same unit.
Independent marginal utility:
The marginal utility which is being derived from the product that is consumed does not get affected by the marginal utility that is actually derived from consuming similar types of goods or services. For example, if you consume a pastry, the utility derived from it will not be affected by the utility which is derived from a muffin.
Importance of Consumer Surplus
As studied, Consumer Surplus is the maximum amount that a consumer is willing to pay for the product minus the price that he actually pays. The consumer surplus thus reflects the amount of utility or the gain which the customers receive when they buy specific products and services from a specific producer. Therefore, consumer surplus is important for the producers who own small businesses, because consumers can derive a large benefit from buying their products and they are more inclined to purchase them again in the future.
Did You Know?
Consumer Surplus was discovered by Jules Dupuit in the year 1884. He was a French civil engineer and an economist. It was later popularized by the British economist Alfred Marshall. The concept was based on the assumption that the degree of satisfaction of consumers (that is utility) can be made measurable.
It is obvious that consumer surplus always increases as the price of a good falls and again it decreases as the price of goods peaks up. Thus, the critics comment about the existence of the consumer surplus. It is all about the play of price, they justify.
Consumer Surplus is used as a tool by the government to formulate tax policies.
By the study of the concept of Consumer Surplus, we are introduced to a good way by which the value of a product or a service is measured. The students are advised to go through this topic and understand the graphs and formulas priorly.
FAQs on Consumer Surplus
1. Is Consumer Surplus good or bad?
As we know that consumer surplus generally occurs when the price of a product or service is lower in value than the price which the consumer is willing to pay. Thus, we see consumer surplus and producer surplus are mutually exclusive, in this sense we can say what's good for someone is bad for the other one.
2. How does demand affect the consumer surplus?
When the price is hiked by 20% but with no effect on demand then the consumer surplus stays high as the demand is not affected by a change in the price, and the consumers are thus willing to pay more for a product. In such an instance, the sellers will increase their prices in order to convert the consumer surplus to their side, that is producer surplus. Conversely, if price hiking affects demand and causes it to fall, the consumer surplus decreases.