When there is a difference between the price that you pay in the market and the value that you place on the product, then the concept of consumer surplus becomes a useful one to look at.
Consumer surplus is a measure of the welfare that people gain from consuming goods and services
Consumer surplus is the difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they actually do pay (i.e. the market price).
Consumer surplus is shown by the area under the demand curve and above the price.
Consumer surplus and price elasticity of demand
When the demand for a good or service is perfectly elastic, consumer surplus is zero because the price that people pay matches what they are willing to pay.
In contrast, when demand is perfectly inelastic, consumer surplus is infinite. Demand does not respond to a price change. Whatever the price, the quantity demanded remains the same. Are there any examples of products that have such zero price elasticity of demand?
The majority of demand curves 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.
When there is a shift in the demand curve leading to a change in the equilibrium market price and quantity, then the level of consumer surplus will change too
Price discrimination and consumer surplus
Producers often take advantage of consumer surplus when setting prices
If a business can identify groups of consumers within their market who are willing and able to pay different prices for the same products, then sellers use price discrimination – this is a way of turning consumer surplus into producer surplus, put simply to make higher revenues and profits.
Airlines and train companies are expert at this, extracting from consumers the price they are willing and able to pay for flying to different destinations are various times of the day, and exploiting variations in elasticity of demand for different types of passenger service.
You will always get a better deal / price with airlines such as EasyJet and Ryan Air if you are prepared to book in advance. The airlines are happy to sell tickets more cheaply because they get the benefit of cash-flow together with the guarantee of a seat being filled. The nearer the time to take-off, the higher the price
If a businessman is desperate to fly from Newcastle to Paris in 24 hours time, his or her demand is said to be price inelastic and the corresponding price for the ticket will be much higher.
Price discrimination and market power
One of the main arguments against firms with monopoly power is that they can exploit their monopoly position by raising prices in markets where demand is inelastic, extracting consumer surplus from buyers and increasing profit margins at the same time.
Geoff Riley FRSA has been teaching Economics for nearly thirty years. He has twenty years experience as Head of Economics at leading schools. He writes extensively and is a contributor and presenter on CPD conferences in the UK and overseas.