Concept of consumer’s surplus and its importance

Consumer surplus is sued 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 representations 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 fill 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 of two consumers). A slightly lower price might induce another customer to purchase the product, or might induce the first consumer 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 black triangle in the diagram. The area reporting consumer’s 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 P 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, Q 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 produce at the price P₁, but are now willing to purchase at the price P. Their consumer surplus is given by the triangular area b in the diagram.

Importance of Consumer’s Surplus:

The concept of consumer’s surplus has both theoretical as well as practical importance.

Theoretical Importance: The idea of consumer’s surplus reveals the benefits which we derive from our purchase of commodity in the market. For example when we purchase salt, or match box, we are willing to pay the amount much higher than their market value. For example a consumer would be willing to pay Rs. 10 for match box rather than go without it. But he actually pays Re one only on the purchase of match box. Consumer’s surplus on the purchase of match box thus is Rs. 9.0.

Practical Importance:

1. A monopolist can charge higher price for his product if the consumer’s are enjoying large consumer’s on the use of his product.

2. The inhabitants of a country derive consumer’s surplus when they import commodities from abroad. They are usually prepared to pay more for them than what they actually pay.

3. A finance minister imposes taxes of the commodities yielding consumer’s surplus.

4. An entrepreneur before investing capital in a project evaluates the consumer’s surplus to be derived from it. If benefits to be obtained are greater than the costs the investment is under taken.