The definition and meaning of consumer surplus is the difference between how much consumers paid for a product or service – the market price – and how much they would be willing to pay – their maximum acceptable purchase price. It is one of the two quantities included in Economic Surplus, which is the consumer surplus plus the producer surplus combined.
The producer surplus is the difference between how much a supplier sold an item for – its market price – and how cheaply he or she would have sold it for – his/her bottom selling price.
Economists say that consumer surplus is a measure of the welfare that individuals gain from consuming products and services. On a supply and demand graph, consumer surplus is shown by the area above the price and below the demand curve, while the producer surplus is the area below the market price and above the supply curve.
Consumer surplus is calculated by subtracting the sale price from the highest acceptable price, and multiplying the result by the number of items sold. Producer surplus is calculated by subtracting the sale price from the minimum acceptable selling price and multiplying the total by the number of items sold. They both make up the economic surplus.
According to the Economist’s glossary of terms, consumer surplus is:
“The difference between what a consumer would be willing to pay for a good or service and what that consumer actually has to pay. Added to producer surplus, it provides a measure of the total economic benefit of a sale.”
Consumer surplus & price elasticity of demand
Price elasticity of demand is a measure of how the demand for a good or service is affected by a change in price.
Demand for a very price elastic product changes by more than the change in its price – for example, if the price of luxury cruises goes up by 5% and demand falls by 10%, luxury cruises are very price elastic.
Demand for price inelastic products, on the other hand, is not affected by price change. If the price of bread in New York goes up by 5%, demand is unlikely to decline anywhere near 5%, if at all.
As you can see in this demand and supply chart, the Consumer Surplus is the pink area above the market price and below the demand curve, while the Producer Surplus is the blue area below the market price and above the supply curve. The equilibrium quantity is equal to both the quantity demanded and the quantity supplied simultaneously. The market price is the amount consumers paid and producers received for each item. Alfred Marshall formalized these ‘surplus’ terms in 1890. (Image: Adapted from Wikipedia)
When demand for a product or service is perfectly elastic, consumer surplus is zero, because the price that consumers pay is exactly the same as the maximum amount they would be willing to pay (their highest acceptable purchasing price).
When demand for a product is perfectly inelastic, on the other hand, consumer surplus is infinite. Whatever the price, demand remains the same.
When demand for a product is inelastic, there is more potential for consumer surplus because there will be some shoppers who are willing to pay a high price to continue buying the product.
Companies commonly raise prices when demand is inelastic, so that the consumer surplus can be turned into producer surplus – if a supplier raises the price, the difference between his or her minimum selling price and how much it is being sold for gets bigger.
Consumer surplus – drinking water
As we now know, consumer surplus is the difference between the top price a consumer is willing to pay and the market price (the actual price they pay). If consumers are unwilling to pay more than the market price, then they are getting more benefit from the bought product than they initially paid.
Take, for example, drinking water, which generally has a high consumer surplus. If we need water to survive, we will pay whatever it takes to stay alive.
The difference in the price that consumers would pay if they had to, and the amount that they currently pay is their consumer surplus.
The utility of the first bottles or liter of drinking water for somebody who is dying of thirst is extremely high, because it prevents death. Therefore, the first liter of drinking water purchased would have more consumer surplus than subsequent purchases.
If I were dying of thirst, I’d pay whatever I had on me plus all the money I could borrow, even if that meant $10,000, for a liter of water. I’d pay less for the second and third liter – there is no way I would ever consider paying $10,000 for subsequent purchases (if dying of thirst were no longer an immediate threat).
Video – Consumer and producer surplus – Definition and Meaning
This ACDC Leadership video explains what the two economic surpluses are. As this footage was launched during the Christmas season, the speaker uses demand and supply of Santa Hats to explain producer surplus and consumer surplus.