By definition consumer surplus refers to the difference between what consumers are willing to pay for a certain good or service and what they actually pay in the market place. It can also be termed as the difference between the value that a level of consumption of a good or service and the amount that they actually pay for it. Meyer D in the ‘Economics of Risk’ defined consumer surplus as the difference between what consumers are willing and able to pay for an activity versus what they actually have to pay for that activity. (Meyer 5). Consumer surplus is the difference between the prices consumers are prepared to pay and the actual price that they pay. Producer surplus refers to the difference between the prices the producers or sellers of a good are willing and able to sell and the price that they actually pay. (McConnel C and Brue S, 433). Setting of prices in this context entails or rather incorporates the aspect of costs incurred and the profit to be earned.
In economics, an important assumption is made in as far as consumer choices are made. It is assumed that all consumers are rational and more often than not they will prefer consuming more goods and services to few. At any given point the consumers’ wants are many and diverse but this is in the face of budgetary or rather income constraints. A demand curve which is downward slopping curve shows the number of units that consumers demand given the various prices in the market. Low prices translated to higher demand as given a specified income one would buy more quantities of cheaper goods as opposed to the expensive ones. (Wessels 52). The aspect of utility is quite critical when addressing the issue of consumer surplus. This is attributed to the fact that consumers, given the budget constraints would be willing to pay higher prices for goods as well as services that they feel would offer them more utility. The demand curve indicates the amount at which consumers are willing to pay additional units of output in terms of goods and services. The downward sloping demand curve nature can be explained by the fact that people will buy more goods when the prices fell and buy less when the prices rose. It can also be explained by the law of diminishing marginal utility which states that the more a consumer consumes a specified good or service in a given period, the lesser the utility derived from consuming an extra unit of that good. Utility refers to the amount or level of satisfaction that a consumer derives after consuming a good or a service. (Mankiw 496).
To illustrate consumer surplus we assume the following prices were attached to respective quantities demanded. The following data and graph were retrieved from http://web.nps.navy.mil/~brgates/documents/micronotes/cs-ps.doc.
Quantity demanded Price of cola in $
2 1 .80
At $1 ten people demanded the ice cones as it was cheaper but fewer consumers demanded it at $1.90, a clear indication that higher price lead to low demand and vice versa. Someone craving for a ice cone on a sunny day may be willing to pay a lot for it due to the fact that he or she will derive a higher utility from the ice cone but on consuming the 2nd 3rd or 4th the utility attained will be decreasing and the consumer will be wiling to pay less for the lesser satisfaction.
Consumer surplus can be defined mathematically as the area under the demand curve but above the equilibrium price. Mathematically, the producer surplus can be defined as the area above the supply curve but below the equilibrium prices. (www.belkcollege.uncc.edu/). There is a difference between the prices that consumers are ready to pay depending on the value placed on the various goods as well as the utility derived and the price they actually pay or the equilibrium price. (McConnel C and Brue S 58). A change in consumer surplus can arise when the equilibrium prices of the commodity in question rises. Consumers are expected to buy as much quantities of a commodity until the marginal utility is equal to the price of the said commodities. When marginal utility is higher than the price consumers will buy more of that good but when prices are higher than the marginal utility then fewer units of that good or service will be bought or consumed.
Producers are out to make profits and they will produce goods that meet the demands of the consumers and at the same time set prices that will cover for the costs incurred in the production of the goods in question and leave an allowance for profits.
When prices of goods are high the producers will produce more goods in an effort to raise their profitability levels. The supply curve will consequently be upward sloping and moving to the right. An equilibrium price must be attained and it ensures that producers do not exploit consumers and producers do not incur losses at the expense of consumers.
Consumer surplus is essential in analyzing welfare gains as well as the losses that are accrued when allocating resources. If people paid the prices they were prepared to pay, then there would be distortions in the market prices. (Nicholson. 402). Equilibrium price which is the price where the quantity demanded is equated to the quantity supplied is the price that tends to prevail in the market for the various goods and services. Charging a price higher than the equilibrium price leads to consumers buying less of that product or service or opting for possible substitutes. It becomes uneconomical for the producers who have to lower it. Charging a lower price attracts a higher demand that may overwhelm the producer leading to a shortage which further causes the prices to rise. (McConnell C and Brue S 48). The forces of demand and supply are to be blamed for the stability of equilibrium prices which have a role to play when analyzing the consumer as well as producer surplus. At equilibrium there is no excess demand or excess supply.
Producer surplus according to Schmid is also referred to as rent and it arises due to the fact that there are decreasing returns to when varying units of a facto of production are of varying quality and productivity and also due to the fact that they are inelastic in supply. Increased production is experienced until the point where marginal revenues are equal to the marginal costs as at this point producers do not incur losses on increasing the production of their output. To capture the producer surplus it is the wish of producers that all units will be sold at the same prices. The idea of equilibrium prices comes to play at this point. Competition in the market also has a role to play in determining not only the quality but also the quantity of goods and services that are to be sold in the market. (Schmid 33).
Motta in ‘Competition Policy’ observed that the producer surplus and consumer surplus had a role to play in determining people’s economic welfare which was a concept to measure a firms well being or performance. The welfare was given by the sum of both the consumer and producer surplus also defined as the total surplus. Surplus from individual consumers was given by the difference between the consumer valuation and the price that was effectively paid. Consumer surplus could also be defined as consumer welfare and it is the aggregate measure of surplus of all consumers. The surplus for individual producer is the gain or profit that producers in a given industry make. It therefore suffices to say that an increase in prices of goods and services translates to reduced consumer surplus while increasing the producer surplus. (Motta 18-20).
- Campbell McConnell, Stanley L. Brue, Campbell R. 2004. Microeconomics: Principles, Problems, and Policies. McGraw-Hill Professional.
- Donald J. Meyer. The Economics of Risk. W.E. Upjohn Institute Publishers. 2003. p 5Consumer and Producer Surplus. Retrieved on 28th November 2008 from http://web.nps.navy.mil/~brgates/documents/micronotes/cs-ps.doc.
- Jack Hirshleifer and Amihai Glazer. Price Theory and Applications: Decisions, Markets, and Information. Cambridge University Press, 2005. 233
- Gregory Mankiw. Essentials of Economics. Harcourt College Publishers 2001
- Massimo Motta. Competition Policy: Theory and Practice. Cambridge University Press, 2004. 25
- Walter Nicholson. Microeconomic Theory: Basic Principles and Extensions. South-Western/Thomson Learning Publishers, 2002. 402
- Walter J. Wessels. 2006. Economic. Barron’s Educational Series Publishers. Supply and Demand. Chapter 3 outline, Principles of Microeconomics. Retrieved on 28th November 2008 from http://www.belkcollege.uncc.edu/azillant/prmicroch3out.pdf.