Consumer Surplus

In this note we look at the importance of willingness to pay for different goods and services. When there is a difference between the price that you actually pay in the market and the price or value that you place on the product, then the concept of consumer surplus becomes a useful one to look at. Defining consumer surplus Consumer surplus is a measure of the welfare that people gain from the consumption of goods and services, or a measure of the benefits they derive from the exchange of goods. 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 for the product). The level of consumer surplus is shown by the area under the demand curve and above the ruling market price as illustrated 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 precisely the price they are willing to pay. This is most likely to happen in highly competitive markets where each individual firm is assumed to be a price taker in their chosen market and must sell as much as it can at the ruling market price. In contrast, when demand is perfectly inelastic, consumer surplus is infinite. Demand is totally invariant to a price change. Whatever the price, the quantity demanded remains the same. Are there any examples of products that have such a low 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 diagram below:

Changes in demand and consumer surplus

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 alter. This is shown in the diagrams above. 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.

Applications of consumer surplus Paying for the right to drive into the centre of London In July 2005, the congestion charge was raised to 8 per day. How has the London congestion charge affected the consumer surplus of drivers?

Transport for London has details on the impact of the congestion charge Consider the entry of Internet retailers such as Last Minute and Amazon into the markets for travel and books respectively. What impact has their entry into the market had on consumer surplus? Have you benefited from you perceive to be lower prices and better deals as a result of using e-commerce sites offering large discounts compared to high street retailers? Price discrimination and consumer surplus Producers often take advantage of consumer surplus when setting prices. If a business can identify groups of consumers within their market who are willing and able to pay different prices for the same products, then sellers may engage in price discrimination the aim of which is to extract from the purchaser, the price they are willing to pay, thereby turning consumer surplus into extra revenue. Airlines are expert at practising this form of yield management, extracting from consumers the price they are willing and able to pay for flying to different destinations are various times of the day, and exploiting variations in elasticity of demand for different types of passenger service. You will always get a better deal / price with airlines such as EasyJet and RyanAir if you are prepared to book weeks or months in advance. The airlines are prepared to sell tickets more cheaply then because they get the benefit of cash-flow together with the guarantee of a seat being filled. The nearer the time to take-off, the higher the price. If a businessman is desperate to fly from Newcastle to Paris in 24 hours time, his or her demand is said to be price inelastic and the corresponding price for the ticket will be much higher.

One of the main arguments against firms with monopoly power is that they exploit their monopoly position by raising prices in markets where demand is inelastic, extracting consumer surplus from buyers and increasing profit margins at the same time. We shall consider the issue of monopoly in more detail when we come on to our study of markets and industries.

:::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::

Consumer Surplus
___________________________________________________________________________________________________________ ___

Have you ever been absolutely indifferent between buying some good at the going price versus doing completely without it? If the market price of something you bought was truly the maximum amount that you would willingly pay for the good, then you received no net gain from its purchase. Consumer surplus is the difference between the amounts people would willingly pay for various amounts of specific goods and the amounts they do pay at market prices. The key to exploring this concept graphically requires recognizing that we can look at individual demand curves for a specific good from two different perspectives:

1. Demand curves are conventionally viewed as answers to the question, How much will be bought at each possible price? The quantity demanded depends on the price. Thus, in Figure 1, at the market price of $50 per video game, this video enthusiast is in equilibrium at point d and buys 10 DVDs per year. 2. Alternatively, we might view demand curves as graphing answers to the question, If people have certain amounts of good X, what is the most they would willingly pay for an extra unit of X?. This alternative perspective views price as depending on quantity. Both approaches yield the same demand curves. Thus, this first figure also indicates that the subjective value (demand price)of the tenth video game per year is $50 at

point d. The ninth game yielded a subjective value of $55, and having an eleventh video game would be worth only $45 to this player. The view that a goods marginal value to an individual depends on the amount consumed is a key to specifying in monetary terms the satisfaction gained from being able to buy at a single market price. In this case, this video game fanatic will pay $500 per year for video games, which equals the area of rectangle 0bda in the Figure 2. The issue, however, is how much this person would be willing to pay for ten new games instead of having zero new video games to play. And the answer, as seen in Figure 3, is that this hobbyist would be willing to pay an amount equal to the total area under the demand curve up to the equilibrium quantity, for a total of $750 annually. This is the area of the trapezoid 0cda. Consumer surplus is the difference between the total subjective value of having a specific quantity of a good instead of doing without, and equals the total subjective value minus the amount actually paid. Thus, the light green triangle bcd represents consumer surplus in this example. In cases where we can represent consumer surplus with simple linear demand curves and fixed market price, this is roughly the area below the demand curve but above the price line, assuming that income effects are trivial. This simple approach can be used as a first approximation of the gains associated with buying a good, and gains or losses of consumer surplus can also be a useful indicator of the relative efficiency generated by private markets or government policies. However, this geometric approach to calculating consumer surplus has some serious limitations. For example, if we are evaluating the efficiency of a policy that affects numerous people, using this approach implicitly assumes that utility or satisfaction can be cardinally measured in monetary terms, that an individuals satisfaction from an extra dollar is not affected by the individuals income level, and most critically, that all the individuals affected derive cardinally comparable amounts of satisfaction from the last dollar allocated in the market being

analyzed. Many economists are convinced that failure of the real world to accord with these strong assumptions is a fatal flaw, and that the concept consequently has no relevance for economic policy or social welfare. The alternative concept of compensating variation avoids some of the weaknesses of consumer surplus as a foundation for analyses of social welfare, but is somewhat more difficult to apply empirically. Thus, even though consumer surplus cannot be measured quantitatively in a cardinal fashion, this concept does permit some useful qualitative assessments of such things as the efficiency of some government policies. See also the concept of compensating variation.

:::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::

Consumer Surplus
The difference between the maximum price that consumers are willing to pay for a good and the market price that they actually pay for a good is referred to as the consumer surplus. The determination of consumer surplus is illustrated in Figure 1 , which depicts the market
demand curve for some good.

Figure 1Calculation of consumer surplus

The market price is $5, and the equilibrium quantity demanded is 5 units of the good. The market demand curve reveals that consumers are willing to pay at least $9 for the first unit of the good, $8 for the second unit, $7 for the third unit, and $6 for the fourth unit. However, they can purchase 5 units of the good for just $5 per unit. Their surplus from the first unit purchased is therefore $9 - $5 = $4. Similarly, their surpluses from the second, third, and fourth units purchased are $3, $2, and $1, respectively. These surpluses are illustrated by the vertical bars drawn in Figure 1 . The sum total of these surpluses is the consumer surplus:

The value $10, however, is only a crude approximation of the true consumer surplus in this example. The true consumer surplus is given by the area below the market demand curve and above the market price. This area consists of a triangle with base of length 5 and height of length 5. Applying the rule for the area of a triangleone half the base multiplied by heightone finds that the value of the consumer surplus in this example is actually 12.5.