Behavior and Choice: EC 102

We will often want a measure for the amount of benefit someone receives from a market transaction (such as a purchase.) In the world of demand, a simple effective measure can be constructed using consumer’s willingness to pay. Consider our mountain bike enthusiast friends from earlier.

If the price in the market is $275, we know that Kyle and Tara will both buy a bike, so \(Q_D = 2\text{.}\) How much does each consumer benefit? Start with Kyle. He was willing to pay $375, but only was asked to pay a price of $275 for the bike. In one sense, then, Kyle receives a benefit of $100. It’s extra money Kyle has in his pocket that he would have paid had the price been higher but does not actually pay, referred to as Kyle’s consumer surplus. Consumer surplus can be calculated as the difference between a consumer’s WTP and the price the consumer actually pays. Similarly, then, Tara receives a consumer surplus of $25. The two consumers who do not buy, Kate and Aaron, each get a consumer surplus of zero. Therefore, at a price of $275, there is $125 of total consumer surplus in the market - $100 goes to Kyle and $25 goes to Tara.

Consumer surplus in the market for mountain bikes when \(P = \$275\)

Consumer surplus does not go negative for Kate or Aaron. If Kate were to buy the bike, for example, she would pay a price of $275 for a bike which she values at $270, which would (hypothetically) give her a “benefit” of -$5. Actually a loss! So instead, as we have shown, Kate chooses not to buy, avoiding the loss and earning a consumer surplus of zero.

Graphically, consumer surplus (CS) can be seen as the vertical distance underneath the demand curve but above the price. With a stepwise demand curve, this is a triangular-ish area underneath the staircase. The far left column is the (large) benefit to the consumer with the highest WTP, and the next column down gives the smaller benefit to the next highest WTP consumer. There is no benefit to the third and fourth consumers since they do not buy.

With more consumers, the same approach can be taken, though the columns under the demand curve get smaller and smaller. What about if there are many consumers? Ultimately, with a smooth demand curve, the consumer surplus would measure the total benefit in the market going to consumers. Since the steps have been smoothed out, so too are the columns of CS: consumer surplus then becomes the area of the triangle under the demand curve and above the price. Despite the different shape, consumer surplus still illustrates the large benefit for the highest WTP consumers, and the very small benefit to the low-but-still-willing-to-buy consumers (WTP of $25.01, price of $25). Moreover, once again, the section of demand to the right of \(Q_D\) captures all of the consumers who are not willing to pay at that price and who receive no benefit.

Key terms in this section:

Practice Problems: Subsection 1.7.4