Consumer Surplus is the difference between what an individual is willing to pay and the actual price that is paid.
Have you ever been to an auction? The auctioneer’s job is to identify the buyer who is willing to pay the most for a product. Most of our purchases are not made where the seller is trying to secure the highest price we are willing to pay. In fact, most of the time we probably would be willing to pay a bit more for a good or service if forced to. We gain if the price we pay is lower than we would be willing to pay. Economists call this gain consumer surplus. The auctioneer strives to eliminate consumer surplus by identifying the individual who is willing to pay the highest price for a product. Even the auctioneer may fail to eliminate the surplus if the final bid is less than the buyer was willing to pay.
To illustrate the concept of consumer surplus, let’s assume that you have three tickets to a Brad Paisley concert. The concert is sold out. An emergency prevents your family from attending. Joy, Linda, George, Kathy, and Michelle are friends who are interested in purchasing the tickets. Brad Paisley is Michelle’s favorite recording artist. She is willing to pay $150 for a seat. George is not a Paisley fan. He would like to attend because he likes country music and wants to hang out with the others, but George would not be willing to pay more than $50 for a ticket. Each friend has a different limit. Economists refer to the maximum a buyer is willing to pay for a good or service as the consumer’s "willingness to pay".
You could sell Michelle a ticket for $150, Joy a ticket for $140, and Linda a ticket for $90, but in the interest of maintaining close friendships you decide to sell your tickets for $90. Michelle is thrilled. She is “saving” $60. This is her consumer surplus, which equals the amount she is willing to pay, $150, less the purchase price $60. Joy is also happy because she has a surplus of $50. Linda is indifferent because the price she is paying is equal to her willingness to pay and she has a consumer surplus of $0. The total surplus is the sum of Michelle’s, Joy’s and Linda’s individual consumer surpluses, or $110. Note that if you chose to sell each ticket at the friend’s willingness to pay, the consumer surplus would be $0. (Michelle and Joy may be happy when they purchase the tickets, but upset when they learn that Linda only paid $90.)
Consumer surplus measures the social benefit to consumers because the price is lower than many would be willing to pay. Assume the graph below is a demand curve for bottled water. The price is $1.75 (P). You are driving a long distance and feel dehydrated. You must have a drink and you are willing to pay $4.00 for a bottle of water which we will assume is more than anyone else. Your demand is represented at point A. The actual price you have to pay is $1.75, so you have an individual consumer surplus of $2.25 (willingness to pay – price paid). This is illustrated by AC. Buyers who are willing to pay more than the price benefit because they pay less than their willingness to pay. The individual consumer surplus would decrease for each additional buyer. For buyers willing to pay $3.00, their consumer surplus would be $1.25 or CF on the graph. Finally, the last buyer would purchase at $1.75 and have no consumer surplus. The total of all individual consumer surpluses is the total consumer surplus and is illustrated by the shaded triangle ABC.