Welfare economics is the study of how the allocation of resources affects economic well-being. Indeed, the main objective of most economic activity is to provide what people most desire. Because people's disposable income is limited, they must decide what they want and what they are willing to pay. However, sellers must decide how much they want to produce and at what price they must charge to make a profit. Although sellers want to sell for the highest possible price, they will also want to sell all that they have produced, so they will have to charge a price low enough to sell their supply.
However, people vary greatly in their desire for a particular product, which is measured by their willingness to pay, which is the maximum amount that a buyer will pay for a good. Some people will not be willing to pay the market price, so they will do without the product. Others are willing to pay much more than the market price, but since the market price is set by competition and the demand for the product, with the result that the same price will be charged to everyone, those people who are willing to pay more for the good will be able to get it for the market price. The amount that a consumer is willing to pay minus the amount that is actually paid results in a consumer surplus for the consumer.
Consumer Surplus = Willingness to Pay Price – Actual Price
Some people are marginal buyers, whose willingness to pay is equal to the market price. Thus, marginal buyers do not enjoy a consumer surplus. The consumer surplus of each individual in a market adds up to the consumer surplus of the market as a whole.
Example — Consumer Surplus
At a local farmers market, 3 Goldendoodle puppies are offered for sale at $600 apiece. There are 3 people at the market who are willing to pay the market price. Barbara is willing to pay $900, Christine is willing to pay $800, and Dan is willing to pay the market price of $600. Therefore, Barbara's consumer surplus is equal to $300, Christine's surplus is equal to $200, and Dan is the marginal buyer who enjoys no consumer surplus in this transaction.
The concept of consumer surplus can be extended to the entire market, where the market surplus is equal to the sum of the consumer surpluses of each individual in the market. For instance, in the above example, the market surplus would be equal to $500, which is the sum of Barbara's consumer surplus plus Christine's consumer surplus.
When graphed, the market surplus is equal to the area under the demand curve which is above the market price.
If the market price drops, then the market consumer surplus increases because the consumer surplus of each individual who was willing to pay the previous market price has increased and because additional buyers whose willingness to pay was below the previous market price but equal to or above the current price purchase the product, adding their consumer surpluses to the market surplus.
Consumer surplus is maximized in a competitive market where the sellers are earning just enough to earn a normal profit. This not only maximizes the consumer surplus of the market, but also ensures the continued production of the good.