Consumer surplus
Consumer surplus is the additional benefit to consumers that they derive when the price they pay in the market is less than the maximum they are prepared to pay.
Consumer surplus is an important concept as it provides a method to evaluate the impact of changes in market conditions, and in terms of the impact of government policy, including the effects of taxation and subsidies.
A demand curve reflects the expected marginal benefit (or utility) derived by consumers when they purchase a given quantity. In the diagram below, the consumer is prepared to pay Py for a single unit Qx given that the expected value of that unit is MU1. However, the actual market price is at P1 - hence there is an additional benefit to the consumer of consuming this single unit at P1 - rather than the higher price, Py. The extra benefit is the consumer surplus, which is shown as the grey shaded area.
As more is consumed, the marginal unitity falls (as a result of the principle of diminishing marginal utility), and the marginal consumer surplus diminishes. In a given market, and assuming consumption is at the equilibrium level, consumers collectively gain the whole area of consumer surplus, as shown.
Total consumer surplus is measured as the area from the price line up to the demand curve.
Consumer surplus and price changes
If price rises, there will be a negative income effect and substitution effect, resulting in reduced demand.
This means that, assuming a fixed budget, less can be purchased (the income effect), and assuming the price of substitutes remains constant, consumers will switch to the alternative (the substitution effect). The result is that consumer surplus falls.
Hence, the higher the price, the smaller the area for consumer surplus, and conversely, the lower the price the larger the area of consumer surplus.
