Consumer surplus measures the welfare that consumers derive from their consumption of goods and services, or the benefits they derive from the exchange of goods.
Consumer surplus is the difference between what consumers are willing to pay for a good or service (indicated by the position of the demand curve) and what they actually pay (the market price).
The level of consumer surplus is shown by the area under the demand curve and above the ruling market price
Consider the demand for public transport shown in the diagram. The initial fare is price P for all passengers and at this price, Q1 journeys are demanded by local users.
At price P the level of consumer surplus is shown by the area APB. If the bus company cuts price to P1 the demand for bus journeys expands and the new level of consumer surplus rises to AP1C. This means that the level of consumer welfare has increased by the area PP1CB.
Consumer surplus = total
willingness to pay for a good or service - the total amount consumers actually
When demand for a product is perfectly elastic, the level of consumer surplus is zero since the price that people pay matches precisely the price they are willing to pay. There must be perfect substitutes in the market for this to be the case.
When demand is perfectly inelastic the amount of consumer surplus is infinite. Demand is invariant to a price change. Whatever the price, the quantity demanded remains the same.
Note that both these situations are highly unlikely to exist - the vast majority of demand curves for goods and services are downward sloping. When demand is inelastic, there is a greater potential consumer surplus because there are some buyers willing to pay a high price to continue consuming the product.
Consumer Surplus and a Shift in Demand
When there is a shift in the demand curve leading to a change in the equilibrium price and quantity traded, the amount of consumer surplus will alter. This is shown in the diagram below. Following an increase in demand for good X from D1 to D2, the equilibrium market price rises to from P1 to P2 and the quantity traded expands. Consumer surplus initially was shown by the triangle AP1C. This rises to area BP2D. There is a higher level of consumer surplus because more is being bought at a higher price than before.
Dynamic Pricing and Consumer Surplus
Dynamic pricing is becoming more common place with the diffusion of information technology in the economy. Dynamic pricing is when the price the firm charges to customers is sensitive to very short run changes in demand. For example, Coca Cola is experimenting in raising the price of cans from vending machines when the average temperature increases.
Hotel bookings systems can change room rates on offer in response to fluctuations in occupancy rates. Changes in price to reflect certain market conditions can take advantage of variations in consumers' willingness to pay for certain items.
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