Consumer Surplus

Consumer surplus (CS) refers to the difference between the highest rate that consumers are ready to pay for the product and the real market rate they paid. Moreover, calculating consumer surplus demonstrates the net benefit gained through product consumption. Additionally, it lies between the demand curve and equilibrium price on the supply and demand curve.

Also known as “social surplus,” it defines the benefit experienced by consumers after purchasing something at a much-decreased rate than predicted. Companies in monopolistic markets with sufficient market power can diminish social surplus, execute price discrimination, and relish profit optimization.

Consumer surplus is an outstanding technique for calculating the worth of a commodity or service, for example, buying a supposedly $500 airplane ticket for $300. Furthermore, monopolies often use the approach to determine the product’s retail price. It is established on the law of diminishing marginal utility devised by the English economist, Alfred Marshall.

According to the hypothesis, the product consumption frequency is inversely related to the consumers’ readiness to invest more in other units. Moreover, Marshall asserts that the more of an item the consumers purchase, the less eager they are to spend more on each of its extra units.

This happens due to the product-derived diminishing marginal utility. The usefulness obtained from the subsequent product consumption is lesser than the primary product utilization.

Meanwhile, let’s check the social surplus theory presumptions:

• Replacements are unavailable.
• The utility is a quantifiable matter.
• The marginal utility of cash is uniform.
• Consumers’ preferences, likings, and earnings are fixed.
• The marginal utility of two similar products is independent of each other.
• Product utilization frequency is inversely proportionate to the marginal utility of each additional unit.

Please note that consumer surplus and producer surplus are two sides of the same coin with different calculation techniques, definitions, and examples. Both demonstrate the economic assessment of consumer and producer benefits, respectively.

The former implies the distinction between the highest rate consumers are keen to pay for the product. However, the latter denotes the difference between the actual price obtained by the producer and the minimum acceptable price.

Let's demonstrate both producer surplus and consumer surplus examples. Consumer Surplus entails buying an airplane ticket for $300 that you were ready to buy for $500. On the flip side, product surplus displays a scenario like purchasing a villa for $10,000, which is more than the expected price of $5000.

Here is the graph used for calculating consumer surplus:

The part beneath the equilibrium price and above the supply curve (green line) is labeled as product surplus (PS). The part above the equilibrium price and underneath the demand curve (red line) is known as consumer surplus.

The demand curve is generally downward-sloping as the product price conversely impacts its demand. Contradictorily, the supply curve is broadly upward sloping since the product price is directly related to its demand. Moreover, the intersection point of the demand and supply curve is called the equilibrium or market price.

While the equilibrium market price is on the y-axis, market quantity is on the x-axis. This is because it strictly follows both the law of demand and the law of supply.

Furthermore, the CS is zero when the product demand is perfectly elastic. Consequently, a slight price alteration extremely affects the product demand. This is because consumers are ready to match its cost but not pay more for the same.

Contrarily, the CS is infinite in the case of perfectly inelastic demand because the rate variations of basic necessities do not influence their demand. Therefore, consumers are ready to invest more in the product. This prompts vendors for price increment and transforms CS into PS.

Moreover, the consumer surplus formula is,

Consumer Surplus Formula = Highest product price consumers are ready to spend – Market price

Now, here are consumer surplus examples:

Example #1

Suppose that Fanny wants to purchase a fully-automatic top load 7kg washing machine with 700 rpm, temperature control feature, and an auto detergent dispenser. He is also ready to spend a maximum of $800. Nonetheless, he discovers a reputed electronic store offering the desired product at just $500.

Now, let’s apply the formula for calculating consumer surplus:

CS = Highest product price consumers are ready to invest – Market price

      = $800-$500

      = $300

Example #2

Google’s pricing power is more extensive due to the absence of any natural limit to the market. Thus, it can charge a rate for its services close to the maximum cost its customers can bear, leading to the limitation of social surplus. Its paying consumers like advertisers do not enjoy social surplus, and so we, as the non-paying users, also carry this loss due to an eventual hike in advertising rates.

The advantages of CS include:

1. Growth expansion for monopolists and businessmen
2. Insightful comparison of benefits of diverse products or facilities
3. Assists in public finance
4. Extremely useful in welfare economics
5. Determining the subsidies
6. Surges foreign trade of useful items
7. Helps justify the launch of a new product