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Consumer Surplus and Consumer Demand - Understanding the Relationship

written by: Christina Pomoni•edited by: Wendy Finn•updated: 8/23/2011

The maximum price consumers are willing to pay for certain goods or services defines their level of satisfaction and the demand for these goods or services. To understand what the consumer surplus is, the characteristics of consumer behavior and the characteristics of the market should be addressed.

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    What's It All About?

    In the context of customer satisfaction, i.e. the satisfaction derived by the goods or services of a company as measured by the number of repeated customers, consumers are not always willing to pay the current market price of certain goods or services. Typically, they are willing to pay more than the current market price because they expect to derive greater satisfaction by entering into a relationship with a particular good or service.

    So, what is the consumer surplus? According to Alfred Marshall, a consumer surplus is the difference between what consumers are willing to pay for a particular good or service and what they actually pay in order not to go without it. For instance, if you are willing to pay $300 for a Blu-ray player, but the player is on sale for $130, you will eventually pay $130 in order to get the good. The consumer surplus is the difference between the price that you are willing to pay for the Blu-ray player ($300) and the current market price ($130). So, eventually you have a consumer surplus of $170.

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    Demand Curve

    Some consumers would buy the Blu-ray player if it is only slightly cheaper than the price they are willing to pay, while others would buy the Blu-ray player only if it is considerably cheaper. So, the willingness of consumers to buy or not to buy the Blu-ray player is the maximum price they would pay for it. And this willingness defines the demand for any good or service.

    We assume that 10 consumers are interested in buying a Blu-ray player. How many of these seven consumers will actually buy a Blu-ray player depends on the current market price of the good. The table demonstrates the amount of money that each consumer is willing to pay for the Blu-ray player and what they actually pay for it. The main assumption is that the current market price of a Blu-ray player is $220.

    consumer-surplus-table Consumer X1 is willing to pay $300, but buys a Blu-ray player paying $220 and has a consumer surplus of $80. Consumer X2 is willing to pay $280, but buys one paying $220 and has a consumer surplus of $60. The same satisfaction is derived up to consumer X6 who is willing to pay $220 and buys a Blu-ray player paying $220, so the consumer surplus is zero. For consumers X7 to X10 the price of $220 is too high, so they don’t buy at all. The total consumer surplus from consumers X1 to X5 is $228.

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    What Happens When Prices Change

    Consumer surplus changes when the current price changes. The question is how much total consumer surplus is affected by an upward or a downward trend in the price of certain goods or services. For instance, in the above example, how much the total consumer surplus will increase if the current market price of the Blu-ray player decreases to $210 from $220? Or how much the total consumer surplus will decrease if the current market price of the Blu-ray player increases to $230 from $220?

    1. Falling current market price

    The table demonstrates the increase in total consumer surplus when the current market price decreases to $210 -- click for a larger view.

    consumer-surplus-table-falling-price 

    Consumer X1 is willing to pay $300, but buys a Blu-ray player paying $210 and has a consumer surplus of $90, earning $10 in consumer surplus from the fall in price to $210. Consumer X2 is willing to pay $280, but buys one paying $210 and has a consumer surplus of $70, earning $10 in consumer surplus from the fall in price to $210. Consumer X6 who had zero consumer surplus at the price of $220 now earns $10 in consumer surplus from the fall in price to $210. For consumers X7 to X10 the price of $210 is still too high, so they don’t buy at all. The total consumer surplus from consumers X1 to X6 is $288, increased by exactly $60.

    The fall in the current market price affects consumer surplus in two ways: 1. for consumers X1 to X5 who would buy the Blu-ray player ever at the price of $220, but at the price of $210 they have higher consumer surplus, and 2. for consumer X6 who would not buy at the price of $220, but at the price of $210 he/she buys because he/she has consumer surplus.

    2. Increasing current market price

    The table demonstrates the decrease in total consumer surplus when the current market price increases to $230.

    consumer-surplus-table-increasing-price 

    Consumer X1 is willing to pay $300, but buys a Blu-ray player paying $230 and has a consumer surplus of $70, losing $10 in consumer surplus from the increase in price to $230. Consumer X2 is willing to pay $280, but buys one paying $230 and has a consumer surplus of $50, losing $10 in consumer surplus from the increase in price to $230. Consumer X6 who had zero consumer surplus at the price of $220 now is not willing to buy at all. The same goes for consumers X7 to X10 the price of $230 is still too high, so they don’t buy at all. The total consumer surplus from consumers X1 to X5 is $178, decreased by exactly $50.

    The rise in the current market price affects consumer surplus in two ways: 1. for consumers X1 to X5 who would buy the Blu-ray player ever at the price of $220, but at the price of $230 they have lower consumer surplus, and 2. for consumer X6 who would buy at the price of $220, but at the price of $230 he/she is not willing to buy because he/she has no consumer surplus.

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    The Law of Diminishing Marginal Utility

    The above example has demonstrated that consumers face a budget constraint. They buy based on the current market price and are willing to pay more than the current market price only if they expect a certain level of satisfaction from buying a good or service.

    marginal-utility Due to this budget constraint, consumers typically increase consumption of certain goods or services and keep the consumption of other goods or services constant. The marginal utility for these particular goods or services decreases as consumption increases. The decline in the marginal utility is explained by the law of diminishing marginal utility.

    The table demonstrates that consumers are willing to buy one item of Blu-ray player if the price is $280. They would be willing to pay for a second item only if the price is $265 and for a third item only if the price is $245, and so on. The additional satisfaction that consumers derive by consuming an additional unit of a good or service is the marginal utility. As the current market price declines, consumers demand more items to derive satisfaction and the marginal utility of each item declines as consumption increases so that price and utility stay in equilibrium.

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    Wrap Up

    Consumers are always willing to derive satisfaction on the goods or services they buy. The degree of satisfaction derived, i.e. the utility of a product or a service, is subject to its current market price. If consumers expect to derive satisfaction by spending $300 on a Blu-ray player, they are willing to spend this amount of money to get the good. But, they find the good on sale, they will certainly buy for less feeling that they got a good deal. So, after all, to understand what consumer surplus is and how it works, one should consider the characteristics of consumer behavior and the characteristics of the market.

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