Consumer surplus

Consumer surplus is the additional benefit to consumers that they derive when the price they pay 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.

A demand curve reflects the expected marginal benefit (or utility) derived by consumers when they purchase a given quantity. In consuming quantity ‘Q1’ at price ‘P1’ the consumer is prepared to pay more than ‘P1’ for units between zero and ‘Q1’.

Consumer surplus is measured as the area from the price line up to the demand curve.

If the price is P1, then the whole area is the value of the consumer surplus. 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.