Consumer Surplus

Consumer Surplus is used to measure the welfare of a group of consumers who purchase a particular product at a particular price. Consumer surplus is defined as the difference between what consumers are willing to pay for a unit of the good and the amount consumers actually do pay for the product. Willingness to pay can be read off of a market demand curve for a product. The market demand curve shows the quantity of the good that would be demanded by all consumers at each and every price that might prevail. Read the other way, the demand curve tells us the maximum price that consumers would be willing to pay for any quantity supplied to the market.

A graphical representation of consumer surplus can be derived by considering the following exercise. Suppose that only one unit of a good is available in a market. As shown in the adjoining Figure, that first unit could be sold at the price P1. In other words there is a consumer in the market who would be willing to pay P1,. Presumably that person either has a relatively high desire or need for the product or the person has a relatively high income. To sell two units of the good the price would have to be lowered to P2. (This assumes that the firm cannot perfectly price discriminate and charge two separate prices to two customers.) A slightly lower price might induce another customer to purchase the product, or, might induce the first customer to buy two units. Three units of the good could be sold if the price is lowered to P3, etc.

The price that ultimately prevails in a free market is that price which equalizes market supply with market demand. That price will be P in the diagram as long as the firms do not price discriminate. Now go back to the first unit that could have been sold. The person who would have been willing to pay P1 for a unit of the good ultimately pays only P for the unit. The difference between the two prices represents the amount of consumer surplus that accrues to that person. For the second unit of the good, someone would have been willing to pay P2 but ultimately pays P. The second unit generates a smaller amount of surplus than the first unit.

We can continue this procedure until the market supply at the price P is reached. The total consumer surplus in the market is given by the sum of the areas of the rectangles. If many units of the product are sold then a one-unit width would be much smaller than shown in the diagram. Thus total consumer surplus can reasonably be measured as the area between the demand curve and the horizontal line drawn at the equilibrium market price. This is shown as the red triangle in the diagram. The area representing consumer surplus is measured in dollars.

Changes in Consumer Surplus

Suppose the supply of a good rises, represented as a rightward shift in the supply curve from S to S' in the adjoining diagram. At the original price P1, consumer surplus is given by the blue area in the diagram. (That's the triangular area between the P1 price line and the demand curve) The increase in supply lowers the market price to P2. The new level of consumer surplus is now given by the sum of the blue and yellow areas in the Figure. (That's the triangular area between the P2 price line and the demand curve) The change in consumer surplus, CS, is given by the yellow area in the Figure. (That's the area denoted by a and b) Note that the change in consumer surplus is determined as the area between the price that prevails before, the price that prevails after, and the demand curve. In this case consumer surplus rises because the price falls. Two groups of consumers are affected. Consumers who would have purchased the product even at the higher price P1, now receive more surplus (P1 - P2) for each unit they purchase. These extra benefits are represented by the rectangular area a in the diagram. Also, there are additional consumers who were unwilling to purchase the product at price P1, but are now willing to purchase at the price P2. Their consumer surplus is given by the triangular area b in the diagram.