Is when the price that a consumer actually pays?

Consumer surplus

Consumer surplus is derived whenever the price a consumer actually pays is less than they are prepared to pay. A demand curve indicates what price consumers are prepared to pay for a hypothetical quantity of a good, based on their expectation of private benefit.

For example, at price P, the total private benefit in terms of utility derived by consumers from consuming quantity, Q is shown as the area ABQC in the diagram.

The amount consumers actually spend is determined by the market price they pay, P, and the quantity they buy, Q – namely, P x Q, or area PBQC. This means that there is a net gain to the consumer, because area ABQC is greater that area PBQC. This net gain is called consumer surplus, which is the total benefit, area ABQC, less the amount spent, area PBQC. Hence ABQC – PBQC = area ABP.

Declining consumer surplus

Consumer surplus generally declines with consumption. One explanation for this is the law of diminishing marginal utility, which suggests that the first unit of a good or service consumed generates much greater utility than the second, which generates greater utility than the third and subsequent units. A very thirsty consumer will be prepared to pay a relatively high price for their first soft drink, but, as they drink more, less utility is derived and the price they would be prepared to pay falls. Therefore, in the above diagram, as consumption rises from zero, at C, to Q, marginal utility falls. As utility falls, the price that consumers are prepared to pay declines, causing the demand curve to slope down from A to B.

Some firms can capture this consumer surplus by charging the highest price that consumers would be prepared to pay, rather than charge price P for all units consumed.

See also: price discrimination.

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Producer surplus

Producer surplus is the additional private benefit to producers, in terms of profit, gained when the price they receive in the market is more than the minimum they would be prepared to supply for. In other words they received a reward that more than covers their costs of production.

The producer surplus derived by all firms in the market is the area from the supply curve to the price line, EPB.

See also: profits

Economic welfare

Economic welfare is the total benefit available to society from an economic transaction or situation.

Economic welfare is also called community surplus. Welfare is represented by the area ABE in the diagram below, which is made up of the area for consumer surplus, ABP plus the area for producer surplus, PBE.

In market analysis economic welfare at equilibrium can be calculated by adding consumer and producer surplus.

Welfare analysis considers whether economic decisions by individuals, organisations, and the government increase or decrease economic welfare.

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Have you ever seen a blockbuster film? Consider the film Avengers: Infinity War. You purchase a Rs 100 movie ticket and, as obvious as it may sound, you thoroughly enjoyed it. Now, if you were asked if you would pay more for that movie, would you? If I had to speak for myself, I would without a doubt. 

However, there is a certain amount that I can pay extra, namely Rs 100, and that Rs 100 is nothing more than our consumer surplus. This is the situation in which you are willing to pay more than the item's actual value, which is referred to as consumer surplus.

Economists use graphs to study and measure the positive feeling you get when you get a great deal. It's known as consumer surplus, and it's the difference between the highest price you'd be willing to pay for something and the price you actually paid.

What is Consumer Surplus?

The law of diminishing marginal utility gives rise to the concept of consumer surplus. According to the law, as we buy more of a commodity, its marginal utility decreases. Because the price is fixed, we get extra utility for all units of the goods we buy. This additional utility is referred to as consumer surplus.

Consumer surplus is defined by Alfred Marshall, a British economist, as "the excess of the price that a consumer would be willing to pay rather than go without a commodity over that which he actually pays."

The economic measure of a customer's excess benefit is known as consumer surplus, also known as buyer's surplus. It is calculated by comparing the consumer's willingness to pay for a product to the actual price they pay, also known as the equilibrium price. When a consumer's willingness to pay for a product exceeds its market price, a surplus exists.

Consumer surplus is based on the economic theory of marginal utility, which is the additional satisfaction gained by consuming one more unit of a product or service. 

Because of differences in personal preferences, satisfaction varies by the consumer. According to the theory, the more of a product a consumer purchases, the less willing he or she is to pay more for each additional unit due to the product's diminishing marginal utility.

How to Calculate Consumer Surplus

The basic formula for calculating consumer surplus is CS = 12 (base) (height), where the equilibrium quantity is the base and the price difference between the high and equilibrium prices is the height. In a competitive market, economists track this information in a graph known as the demand curve. Here's how to graph this data:

1. Market price: Plot the rising market price of the product on the y-axis (vertical axis) of the graph.

1. Market quantity: Plot the number of goods available in the marketplace on the x-axis (horizontal axis) of the graph.

1. Demand curve: Track demand by plotting the price at which goods were sold in relation to the quantity of products available. The demand curve is the line that slopes downward from left to right. This is consistent with the law of diminishing marginal utility, which states that as consumption increases, so does marginal utility.

1. Supply curve: Determine the supply curve by plotting the price-to-quantity relationship from the seller's or producer's point of view. From left to right, this line ascends.

1. Market equilibrium: The equilibrium price denotes the point at which the price matches the demand. The equilibrium quantity is a horizontal line that represents the point at which there is neither a shortage nor a surplus of goods. 

Where these two factors intersect indicates where there is a price-demand balance. The equilibrium point appears on the graph where the supply and demand curves cross, and it is referred to as such.

1. Consumer surplus: Purchases made above the equilibrium price but below the demand curve form a triangle, the area of which is consumer surplus. As a result, the consumer surplus formula is based on the area of a triangle: 12 (base) CS (height).

1. Deadweight loss: A deadweight loss occurs when the socially optimal amount of a good is not produced. If the actual quantity produced is less than the equilibrium quantity, this region will be visible on the graph. It will reduce both the size of the consumer surplus and the size of the producer surplus.

Limitations of Consumer Surplus

Below are some of the limitations of consumer surplus :

1. The marginal utilities of different units of a commodity consumed by a person are difficult to calculate. As a result, precise measurement of consumer surplus is impossible.

1. The marginal utilities of the first few units of a necessary good are infinitely large. As a result, the consumer surplus for such goods is infinite.

1. The availability of substitutes has an impact on the consumer surplus as well.

1. It is extremely difficult to calculate the utility-scale for prestigious goods such as diamonds.

1. We cannot quantify the consumer surplus in monetary terms. This is due to the fact that the marginal utility of money changes as a consumer makes purchases and his money stock depletes.

This concept is only acceptable if we can measure utility in terms of money or something else. Many modern economists are opposed to the idea.

Consumer Surplus and Producer Surplus

The total surplus in a market is a measure of the overall well-being of all market participants. It is the sum of the consumer and producer surpluses.

Calculation of Consumer Surplus and Producer Surplus

1. Consumer surplus is the difference between what consumers are willing to pay for a good and what they actually pay for it. Each price along a demand curve also represents the marginal benefit of each unit of consumption for the consumer. 

The difference between a consumer's marginal benefit for a unit of consumption and what they actually pay represents the amount of benefit a consumer receives from the price they pay.

1. Consumers who pay a lower price than they would have been willing to pay benefit from the welfare or benefit. Graphically, the area below the demand curve and above the market price.

1. The difference between the price a seller receives and their willingness to sell for each quantity is referred to as the producer surplus. Each price on a supply curve represents the seller's marginal cost of producing each unit of production. 

As a result, the difference between the seller's price for each unit and the cost of producing that last unit represents the seller's benefit from the price they are receiving.

1. The benefit or welfare enjoyed by producers who sell at a price higher than the price at which they would have been willing to sell. Graphically, the area above the supply curve and below the market price.

Also Read | Demand and Supply Analysis

Consumer Surplus vs Economic Surplus

Consumer surplus is defined in mainstream economics as the difference between the highest price a consumer is willing to pay and the actual price they pay for the good.

Economic surplus consists of two interconnected quantities: consumer surplus and producer surplus. The difference between what a consumer is willing to pay and what they actually pay for a good or service is referred to as consumer surplus.

The producer surplus is the difference between the market price of a good or service and the lowest price a producer would accept for a good. The surplus benefit experienced by both consumers and producers in an economic transaction is added together to calculate the economic surplus.

Economic Surplus Example

Assume that the manufacturer of the sneakers must spend Rs 2000 on each pair of sneakers to manufacture, market (advertise), and distribute.

The manufacturer of the sneakers does not want to lose money by selling the shoes, so Rs 2000 is the bare minimum they are willing to charge.

The manufacturer must then decide on a price that will make the sneakers appealing to a wide range of consumers. (If the sneakers cost Rs4000, the sneaker manufacturer will make a Rs 2000 profit on each pair sold.) This profit is referred to as the producer's surplus.

Consumer Surplus Example

 Most consumers decide how much they are willing to spend on an item before making a purchase. If the sneakers cost Rs 70000, the student may decide not to purchase them. However, if the sneakers cost Rs 40000, the student is more likely to buy them. 

In economic terms, they've made a Rs 30000 profit: the difference between the student's maximum willingness to spend (Rs 60000) and the market price of the sneakers (Rs 40000). 

A surplus represents a monetary gain for consumers because it allows them to purchase an item for less than the highest price they are willing to pay.

Also Read | Elasticity of Demand and its Types

Examples of Consumer Surplus

1. Cell phones: A cell phone provides consumers with enormous utility: communication with the outside world. As a result, even if the market price is high, consumers are often willing to pay more than the market price to secure a cell phone. 

Consumer satisfaction, however, will decrease with each subsequent purchase of a replacement phone, according to the law of diminishing marginal utility.

1. Airline tickets: Airline ticket prices fluctuate rapidly, with countless websites dedicated to providing consumers with the best deal possible. If you were willing to pay Rs 35000 for a flight from New York to Los Angeles but only paid Rs 21000, you would receive Rs 14000 in consumer surplus. 

Sellers, on the other hand, are aware that you are willing to pay more for a flight and will raise ticket prices prior to important dates such as Thanksgiving or summer vacation, converting consumer surplus into producer surplus.

1. Gasoline: People frequently drive further to ensure a lower price per gallon to refill their car's gas tank, but they are willing to pay more to avoid running out of gas. Consumer surplus is the money you save by driving to a lower-cost gas station. 

For example, if gas costs Rs 3000/gallon in a city and Rs 2000/gallon elsewhere, your consumer surplus is Rs1000/gallon. Gasoline, for example, can have a ceiling price, which limits how much companies can charge for goods. 

Price ceilings are typically applied to everyday items such as gas, food, and medicine. A price ceiling can result in deadweight loss, which reduces both consumer and producer surplus.

Also Read | What is Price Ceiling and Price Floor?

It is critical to fully grasp the concept of consumer surplus. It can assist in making business decisions related to price-output setting, value pricing, and price discrimination in the context of various marketing strategies.

It must be acknowledged that a trade-off exists between consumer surplus and revenue generated. If the emphasis is placed on increasing revenue by raising the price of the product, the surplus will deteriorate. 

This scenario may result in higher earnings, but it is accompanied by a relative weakening of the firm's position among competitors offering similar products. To ensure that the consumer surplus is not adversely affected, the price must be set with extreme caution.

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