What is consumers surplus?
Consumer surplus is basically an economic measure of consumer benefit, which is calculated by analyzing the difference between what consumers are willing and able to pay for a good or service relative to its market price, or what they actually do spend on the good or service.
A consumer surplus occurs when the consumer is willing to pay more for a given product than the current market price.
When understanding consumer surplus, try to remember that a surplus is not good, or inefficient, just as a shortage is.
An example of a product that enjoys a consumer surplus is petrol / gasoline. Gas prices tend to be higher during the day because more people are on the roads. If you want cheap gas, you either fill up your car at night, or go to a small town outside of a main city where it is cheaper.
However, if your car is about to run out of gas at mid-day, you won’t take into account that you are purchasing it above the best price possible because you need it to get home; this is consumer surplus.
Consumer surpluses benefit the producer – the oil companies – because you are paying more than the lowest possible price for that product or service; hence, why gas and energy providers charge more for their products during daytime hours.
Consumer Surplus or Buyer’s Surplus is an economic measurement of the customer’s excess benefit. In an economy, a consumer surplus takes place when the consumer is willing to pay more for a product than its market price. Consumer Surplus is an important study in the subject of Economics. Here, we are going to provide insights on “What is Consumer Surplus?”
Consumer’s Surplus = The price a consumer is ready to pay – The price he actually pays
Further, the consumer is in equilibrium when the marginal utility is equal to the price. That is, he purchases those many numbers of units of a good at which the marginal utility is equal to the price. Now, the price is fixed for all units. Hence, he gets a surplus for all units except the one at the margin. This extra utility is consumer surplus.
Let us take a look at an example of consumer surplus.
|No. of units||Marginal Utility||Price (Rs.)||Consumer’s Surplus|
From the table above, we see that as the consumption increase from 1 to 2 units, the marginal utility falls from 30 to 28. This diminishes further as he increases consumption.
Now,Marginal utility is the price the consumer is willing to pay for that unit.
The actual price of the unit is fixed.
Therefore, the consumer enjoys a surplus on all purchases until the sixth unit. When he buys the sixth unit, he is in equilibrium, since the price he is willing to pay is equal to the actual price of the unit.
Examples of Consumer Surplus
Here’s how consumer surplus plays out in real life.
Airline tickets: Airline ticket prices change rapidly, with countless sites dedicated to guaranteeing consumers the lowest price. If you’re willing to pay Rs5000 for a flight from New Delhi to Ludiana , but end up paying Rs3000, you receive Rs2000 in consumer surplus. Sellers, however, know that you are willing to pay more for a flight, and will increase ticket prices before important dates like Thanksgiving or summer vacation, thereby turning consumer surplus into producer surplus.
Petrol/Gasoline: People often drive further to guarantee a lower price per gallon to refill their car’s gas tank, but they would be willing to pay more to avoid running out of gas. The money you save by driving to a gas station with lower prices is consumer surplus. For example, if Pertol/gas costs Rs100/litre in an urban area and Rs150/litre out of town, your consumer surplus is Rs50/litre. Goods likePetrol/LPG also can have a ceiling price, which caps how much companies can charge for goods. Price ceilings typically apply to normal goods like gas, food, or medicine. A price ceiling can cause deadweight loss, reducing consumer and producer surplus.
Cell phones: A cell phone provides immense utility to consumers: communication with the outside world. Therefore, consumers are often willing to pay more than the market price to secure a cell phone—even if the market price is high. According to the law of diminishing marginal utility, however, consumer satisfaction will decrease with each subsequent purchase of a replacement phone.
For a better picture, let’s look at an example:
A shopper is browsing for a new television. Specifically, she wants a Cell phone, and she’s set a maximum budget of Rs5,0000. To her joy and surprise, she finds a Smart Phone meeting all of her exact requirements for only Rs39500.
That Rs10500 cost difference of what she paid versus what she was willing to spend is her consumer surplus, which she is now free to spend on other products, goods, or services.
To put it in the simplest terms, consumer surplus is when you think you got a good deal because you paid less than you were expecting to.
Consumer surplus = Maximum price willing to spend – Actual price
In our earlier example with the Smart Phone Purchase, we can see that consumer surplus equals Rs5,0000 minus Rs39500 to give us a total of Rs10500 for our surplus.
Consumer surplus = (½) x Qd x ΔP
The customer is willing to spend Rs50000 on a new energy drink, but most customers are willing to pay only Rs39500, which is the equilibrium point where supply meets demand. At a Rs39500 retail value, the company supplies a store with 100 Pieces to meet the demand.
Plugging these values into our formula gives us (½) x 100 x (Rs50000 – Rs395000) for a total of Rs10500 consumer surplus shared among the customers who made a purchase at the equilibrium price point. Those savings can go toward other products and services.
What is Company/Producer/Manufacturer SURPLUS?
Supply and demand are all about balance, so the opposite side of the equation results in a producer surplus, which is the difference between the minimum price a producer is willing to accept for their goods or services and the final price they receive. A surplus happens when market prices exceed the lowest price point that a producer will accept.
Let’s look at an example to better understand producer surplus.
Understandably, producers can’t earn a profit if they aren’t able to recoup at least the marginal cost they spent to produce and transport their products. A free market has this natural push-pull effect that prevents either the consumer or the producer from fully dictating price points.
Producer surplus = Total revenue – Total cost
A Bike manufacturer decides to produce 10,000 of its newest sports model this year.
Over the past few years, the standard selling price has been Rs90,0000 for this type of vehicle, but this year, the economy is stronger than it’s been in the past, and many consumers are paying more, up to Rs150,0000 in some cases since the supply is limited and the demand is higher than expected.
If a bike buyer spends Rs150,0000 on a vehicle instead of the expected Rs90,0000, the difference of Rs60,0000 is the producer surplus.
In simplest terms, producer surplus happens when a producer receives more revenue than expected for a good or service
What is a Demand Curve?
According to the law of demand, when product price decreases, its demand increases and vice-versa. The fundamental principle charts the change in the demand for goods (measured in quantity) at different price levels.
Movements Along the Demand Curve
Upward and downward movements on the graph are brought out by changes in price (and not other factors). There is an inverse relationship between price and demand.
Upward Movement: If the curve moves upward, the price of goods increases—demand falls at the same rate.
Downward Movement: On the other hand, if there is a downward movement, the price of the goods falls—demand rises proportionately.
A demand curve is a graphical representation of a change in product demand brought out by a change in price. A product’s price is inversely related to demand—provided other factors remain constant.
Any increase or decrease in demand due to a fall or rise in price is depicted by a downward or upward movement.
The curve shifts rightward or leftward when there is an increase or decrease in the product requirement. In addition to price, Demand changes are brought out by consumer income, consumer preference, consumer expectation, and the supply of goods.
The demand curve correlates goods demand at various price levels. Demand can be elastic or inelastic. Elasticity here refers to demand being sensitive to price. Alternatively, in certain markets, demand is not affected by the change in price—inelastic demand.
In economics, the demand curve is based on the law of demand. The law of demand depicts an inverse relationship between goods price and goods demand. Based on price changes, the curve can shift downward or upward. Hence, the law of demand renders a downward sloping curve—demand goes up when goods price falls.
What are the reasons for shift in demand curve?
A demand curve is plotted to show the relationship between price and quantity demanded of a commodity keeping all other factors unchanged. However when we talk about the real world, demand does get affected by these other factors and any change in them leads to a shift in demand curve.
That is, when the demand of a commodity changes due to change in any factor other than the own price of the commodity, it is expressed as a shift in the demand curve.
These factors include following among others.
Price of related goods – Let us take the case of substitutes (tea and coffee). Say our good in consideration is tea. Price of coffee increases. This would lead to an increase in demand for tea as people would shift from coffee to tea as tea has become relatively cheaper. Hence demand curve for tea would shift right.
Consumer’s income – An increase in income causes demand for normal goods to increase and hence demand curve would shift to right as consumer will demand more for that normal good at same prices now.
Expectations – If people foresee a fall in prices of the good in the future they would decrease their demand for the good today hence shifting the demand curve to the left.
Tastes and Preferences – If preferences changes in favour of the said commodity, demand curve would shift to the right. Such as umbrellas during rainy season or jewellery in wedding season.
Elastic Demand Curve Example
The price of soft drinks is $3 per can, and the market demand is 40,000 cans per month. Next month, the price goes up to $3.50, and the demand falls to 30,000 cans. Then, in the consecutive month, the price changes to $4—demand further goes down to 25,000 cans. Later price hits $5 per can, and demand plummets to 15,000 cans per month. Plot the demand curve graph.
Relevance and Use of Elastic Demand Formula
Based on this concept, companies can make important product pricing decisions.
If a product falls under the elastic demand curve, substitutes can easily replace that product. Therefore, companies should prepare a price-volume analysis before increasing the price of products.
On the other hand, if the product has an inelastic demand curve (availability of substitutes), companies can increase their prices.
This selling strategy involves charging different prices for the same goods or services based on the business’s estimation of the maximum amount they think the customer is willing to pay.
For example, suppose you’re looking at renting a house on the beach for a week. In that case, the exact same house is going to cost a lot more if you’re renting during peak tourist season versus the off-season when the renter is desperately trying to prevent the house from sitting empty.
Most brand-name goods know that there’s power in a name and people are willing to pay much more to be “on brand” rather than buy a cheaper, almost identical alternative that’s lacking a famous logo.
Airlines are also notorious for price discrimination. They know that people are willing to pay more for convenience.
Because there’s less of a demand for early morning and late-night flights, the airline is able to price fares differently depending on the time of day, even though the cost of flying and fueling a plane from Destination A to Destination B isn’t going to change. This is called the elasticity of demand.
WHAT IS SOCIAL SURPLUS?
Also referred to as economic surplus or total surplus, a social surplus is the sum of consumer surplus and producer surplus. When looking at a demand-supply graph, the social surplus is the total area between the supply curve, the demand curve, and the point of equilibrium.
A deadweight loss, which occurs when the economy is producing at an inefficient quantity, is the loss in total surplus.
When the market is operating at optimal efficiency, it’s impossible to increase consumer surplus without reducing producer surplus, and it’s also impossible to improve producer surplus without lowering consumer surplus.
Total surplus is larger at equilibrium quantity and price than it would be at any other quantity and price.
HOW DO PRICE FLOORS AND PRICE CEILINGS AFFECT THE MARKET?
A healthy market is able to adapt and settle naturally on an equilibrium point that balances price and quantity. Imposing a price floor or ceiling prevents the market from adjusting to its ideal point of equilibrium and maximum efficiency while also transferring some of the consumer surplus to producers and vice-versa.
A price ceiling is a maximum price a producer is allowed to charge consumers in exchange for a good or service.
The government’s impact on the drug market is an excellent example of price ceilings. Let’s say that a pharmaceutical company created a new life-saving drug. The market-price equilibrium, if left to the free market without any restrictions, would be $800, with an expected 50,000 people using the drug per month.
But the government wants to make the drug more affordable, so it imposes a price ceiling at $500.
So, what happens?
First, the pharmaceutical company is going to produce a lower amount of product. Their supply is going to reflect the price ceiling line on the graph instead of the market equilibrium point. This reduces the social surplus and increases deadweight loss. Basically, money is being discarded without benefitting anyone.
In addition, some of the producer surpluses end up being transferred to consumers, which is why consumers largely favor price ceilings. However, the gain to consumers is less than the loss to producers, aka still a deadweight loss. The market is not operating as efficiently as it could be.
A price floor is the lowest price that can legally be paid for goods or services.
Salesman’s Answer Consumer Questions
Is there any benefit in understanding consumer surplus?
Yes, there is a great benefit to understanding consumer surplus. If you are a consumer, knowing about consumer surplus empowers you to make smart long term definitions. For example, if you buy a product at a price less than you’re willing to spend, you know you have a consumer surplus. This concept can guide you to a decision to either spend or save that “surplus” based on your needs and wants.
Who is affected by consumer surplus?
Consumers and producers are affected by consumer surplus. A consumer is obviously affected by a consumer surplus because it provides a concept on how to approach paying for goods or services. Similarly, a producer needs to consider the difference in which they are willing to set a price against what is the greatest amount of goods or services they can sell. This in part is based on the where the consumer surplus ends at equilibrium.
Market Needs… Market Pulse…
The market is fluid. When it’s allowed to operate freely, consumers and producers tend to push and pull until equilibrium is reached and the market is able to regulate its supply and demand with maximum efficiency.
Understanding the basics of supply and demand; consumer, producer, and social surplus; price discrimination; deadweight loss; price ceilings; and price floors are critical to making comprehensive business decisions about quantity and pricing.