Author: Geoff Riley Last updated: Sunday 23 September, 2012
When there is a difference between the price that you pay in the market and the value that you place on the product, then the concept of consumer surplus becomes a useful one to look at.
Consumer surplus is a measure of the welfare that people gain from consuming goods and services
Consumer surplus is the difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they actually do pay (i.e. the market price).
Consumer surplus is shown by the area under the demand curve and above the equilibrium price as in the diagram below.
Consumer surplus and price elasticity of demand
When the demand for a good or service is perfectly elastic, consumer surplus is zero because the price that people pay matches what they are willing to pay.
In contrast, when demand is perfectly inelastic, consumer surplus is infinite. Demand does not respond to a price change. Whatever the price, the quantity demanded remains the same. Are there any examples of products that have such zero price elasticity of demand?
The majority of demand curves are downward sloping. When demand is inelastic, there is a greater potential consumer surplus because there are some buyers willing to pay a high price to continue consuming the product. This is shown in the next diagram.
When there is a shift in the demand curve leading to a change in the equilibrium market price and quantity, then the level of consumer surplus will change too
In the left hand diagram, following an increase in demand from D1 to D2, the equilibrium market price rises to from P1 to P2 and the quantity traded expands. There is a higher level of consumer surplus because more is being bought at a higher price than before.
In the diagram on the right we see the effects of a cost reducing innovation which causes an outward shift of market supply, a lower price and an increase in the quantity traded in the market. As a result, there is an increase in consumer welfare shown by a rise in consumer surplus.
Consumer surplus can be used frequently when analysing the impact of government intervention in any market – for example the effects of indirect taxation on cigarettes consumers or the introducing of road pricing schemes such as the London congestion charge or a rise in air passenger duty.