Consumer Surplus

Welfare economics is the study of how the allocation of resources affects economic well-being. Indeed, the 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 profit. Although sellers want to sell for the highest possible price, they also want to sell all their production, so the price must be low enough to sell their supply.

People vary greatly in their desire for a particular product, which is measured by their willingness to pay, the maximum amount a buyer will pay for a good or service. Some people will not pay the market price, so they will do without the product. Others would pay much more than the market price, but since the market price is set by competition and by market demand for the product, so the same price is charged to everyone, those people willing to pay more for the good can just pay the market price. The amount a consumer is willing to pay minus the amount actually paid is the consumer surplus for the consumer.

Consumer Surplus = Willingness to Pay Price − Market Price

Some people are marginal buyers, whose willingness to pay = the market price. Thus, marginal buyers do not enjoy a consumer surplus.

Market Surplus

The concept of consumer surplus can be extended to the entire market, where the market surplus equals the sum of the consumer surpluses of each person in the market. For instance, in the above example, the market surplus would = $500, the sum of Barbara's consumer surplus + Christine's consumer surplus.

Consumer surplus diagrams showing that the market surplus equals the area under the demand curve that is above the market price.
When graphed, the market surplus = the area under the demand curve above the market price.

Example: Consumer Surplus

At a local farmers market, 3 puppies of a special breed are offered for sale at $600 apiece. Some people at the market 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 $300, Christine's surplus is $200, and Dan is the marginal buyer who gets no consumer surplus in this transaction.

If the market price drops, then the market consumer surplus increases because the consumer surplus of each person willing to pay the previous market price has increased and because additional buyers — whose willingness to pay was below the previous market price but above the current price — buy the product, adding their consumer surpluses to the market surplus.

Consumer surplus is maximized in a competitive market when 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 or service.