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Consumer Surplus

The economic measure of a customer’s benefit

What is Consumer Surplus?

Consumer surplus, also known as buyer’s surplus, is the economic measure of a customer’s benefit. It is calculated by analyzing the difference between the consumer’s willingness to pay for a product and the actual price they pay, also known as the equilibrium price. A surplus occurs when the consumer’s willingness to pay for a product is greater than its market price.

 

Consumer Surplus

 

Consumer surplus is based on the economic theory of marginal utility, which is the additional satisfaction a person derives by consuming one more unit of the product or service. The satisfaction varies by consumer due to differences in personal preferences. By theory, the more of a product a consumer owns, the less willing he/she is to pay more for the product due to the diminishing marginal utility derived from the product.

 

Calculating Consumer Surplus

 

Consumer Surplus Chart

 

The point where the demand and supply meet is the equilibrium price. The area above the supply level and below the equilibrium price is called product surplus (PS), and the area below the demand level and above the equilibrium price is the consumer surplus (CS).

While taking into consideration the demand and supply curves, the formula for consumer surplus is CS = ½ (base) (height). In our example, CS = ½ (40) (70-50) = 400.

 

Consumer Surplus and the Price Elasticity of Demand

Consumer surplus for a product is zero when the demand for the product is perfectly elastic. It is because consumers are willing to match the price of the product. When demand is perfectly inelastic, consumer surplus is infinite because a change in the price of the product does not affect its demand. It includes products that are basic necessities such as milk, water, etc.

Demand curves are usually downward sloping because the demand for a product is usually affected by its price. With inelastic demand, high consumer surplus is high because the demand is not affected by a change in the price, and consumers are willing to pay more for a product.

In such an instance, sellers will increase their prices to convert the consumer surplus to a producer surplus. Alternatively, with elastic demand, a small change in price will result in a large change in demand. It will result in a low consumer surplus as customers are no longer willing to pay as much of the product or service with a change in price.

 

Law of Diminishing Marginal Utility

According to economist Alfred Marshall, the more you consume a certain commodity, the lower the satisfaction derived from each additional unit of consumption. For example, if you buy one apple for $0.50, you are not willing to pay more for the second apple. At the same time, the utility derived from consuming the second apple is lower than it was for the first apple. The concept is described in the table below:

According to Alfred Marshal: Consumer Surplus = Total Utility – (Price x Quantity)

 

Law of Diminishing Marginal Utility - Table

 

Assumptions of the Consumer Surplus Theory

 

1. Utility is a measurable entity

The consumer surplus theory suggests that the value of utility can be measured. Under Marshallian economics, utility can be expressed as a number. For example, the utility derived from an apple is 15 units.

 

2. No substitutes available

There are no available substitutes for any commodity under consideration.

 

3. Ceteris Paribus

It states that customers’ tastes, preferences, and income do not change.

 

4. Marginal utility of money remains constant

It states that the utility derived from the income of a consumer is constant. That is, any change in the amount of money of a consumer does not change the amount of utility they derive from it. It is required because without it, money cannot be used to measure utility.

 

5. Law of diminishing marginal utility

It states that the more a product or service is consumed, the lower the marginal utility is derived from consuming each extra unit.

 

6. Independent marginal utility

The marginal utility derived from the product being consumed is not affected by the marginal utility derived from consuming similar goods or services. For example, if you consumed orange juice, the utility derived from it is not affected by the utility derived from apple juice.

 

Conclusion

Consumer surplus is a good way to measure the value of a product or service and is an important tool used by governments in the Marshallian System of Welfare Economics to formulate tax policies. It can be used to compare the benefits of two commodities and is often used by monopolies when deciding the price to charge for their product.

 

Additional Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Aggregate Supply and Demand
  • Normal Goods
  • Purchasing Power Parity
  • Supplier Power

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