Consumer and Producer Surplus

Consumer Surplus

Consumer surplus is the difference between the maximum price a seller is willing to pay for a good or service and the actual market price the buyer pays.
In a free-market economy, prices are set by the market. This means prices are determined by how much consumers are willing to pay and how much sellers are willing to accept. Market price is established where quantity supplied, the quantity of a good or service that producers offer for sale at a specific price, equals quantity demanded, the quantity of a good or service that consumers are willing and able to buy at a specific price. This provides a single market price and a single quantity of goods in the market, both determined by the point where the supply and demand curves intersect on a graph. According to the law of demand, the demand for a good or service increases as the price decreases, and the demand decreases as the price increases. According to the law of supply, as the price of a good or service increases, the quantity supplied will increase, and as the price decreases, the quantity supplied will decrease.

Consumer surplus is the difference between the maximum price that an individual consumer (or the market) would be willing to pay to receive a good or service and the actual market price that they have to pay. Every potential consumer has a maximum price point that they are willing to pay. This price reflects the value that the potential consumer has for that particular good or service. The consumer's willingness to pay also reflects the opportunity cost of the purchase: the value or benefit of the next best alternative given up when making a choice. How much value the potential buyer has for the purchase, relative to what else the buyer could spend money on, determines the buyer's willingness to pay. Paying just a penny above this would be too costly as far as the consumer is concerned. Above this price point, the consumer is no longer in the market for the good or service.

The concept of maximum willingness to pay offers a different way to consider a demand curve, or a line on a graph showing different combinations of quantities demanded and prices, which can also be used to show the maximum price that an individual consumer (or the demand side of the market) would be willing to pay. For example, assume individual consumers are willing to pay different maximum amounts for their morning coffee, ranging from $0.10 on the low end to $4.00 on the high end. This can be represented on a demand schedule, a table that shows the quantity demanded of a good at different prices which can also be used to show the maximum price that a consumer would be willing to pay.

It's important to note these basic calculations do not take into account every possible factor that could impact demand and the price consumers are willing to pay. Ceteris paribus is a Latin term meaning "all other things being equal." In economics, ceteris paribus means all other variables are being held constant or no other changes are occurring at the same time. Ceteris paribus is an important concept in economics because in real life many aspects of the economy are in motion at the same time. In order to study the effect of prices on the quantity of a good demanded by consumers, all other variables must be held constant.

Demand Schedule for Coffee
Potential Customer Willingness to Pay
Andrea $4.00
Brett $3.00
Christy $2.50
Deb $1.99
Eddie $1.00
Frank $0.10

The demand schedule for coffee shows us how much each consumer is willing to pay for one cup of coffee.

A demand schedule can be used to create a demand curve for this market.
The market for coffee only has six potential customers, so the demand curve for coffee is step-shaped. Each step represents one consumer, and the height of the step is equal to the price each is willing to pay for a cup of coffee. This is based off of the assumption that people will always buy a cup of coffee if the price is below what they're willing to pay.
Each customer's willingness to pay corresponds to a spot on the market demand curve. Note that the demand curve is downward sloping, indicating that as the price of a cup of coffee goes down, the quantity demanded in this market for coffee increases. In this scenario, if a cup of coffee is $4 the only individual out of six who will pay for it is Andrea. If the market price of a cup of coffee is $2, Andrea's individual consumer surplus is $2. Three out of the six individuals are willing to pay $2 for a cup of coffee. If the price then went down to $0.75, there would be five individuals willing to buy a cup of coffee, thus the quantity demanded of coffee would increase because it is likely these five individuals would buy a cup.
Each individual's consumer surplus is the difference between the maximum amount they are willing to pay and the market price that they actually paid. Any individual whose willingness to pay is below the market price ($2.00) chooses not to make a purchase. Deb is only willing to pay $1.99, so she does not purchase coffee, although the market price is very near her willingness to pay.