Consumer surplus illustrated

In economics, the concept of producer surplus is relatively intuitive to understand. It is the difference between what the seller receives for selling the good or service, and the seller's costs. That is effectively their profit (or, to be more correct, it's their profit if you ignore any fixed costs).

The concept of consumer surplus has a similar interpretation conceptually, but intuitively consumer surplus is more difficult to understand. It is the difference between the maximum that the buyer is willing to pay for the good or service, and the price that they actually pay.

Here's an illustration. After a tragic accident delaminated the sole of my shoe yesterday, I find myself in need of a new pair of sneakers. I went to The Warehouse this morning, and picked out a nice new pair, with a stated price of $35. Having satisfied myself that this was a good buy, I headed for the checkout.

When I arrived at the (self-service) checkout and scanned the barcode, the price came up as $19.98. Even better! I was happy to buy the shoes for $35, but now I was getting them for $19.98 instead. I have an extra $15.02 left in my bank account after the purchase than what I had anticipated. That $15.02 is consumer surplus. [*] You can think of it as a sort of profit that the buyer receives.

Consumer surplus is a measure of the benefit that buyers receive from participating in the market. If the consumer chooses not to buy, then there is no surplus - they will only buy if the price is not higher than the maximum they are willing to pay, and that means that some consumer surplus will be generated from every willing transaction between a buyer and a seller.

When we add the consumer surplus and producer surplus (and sometimes some other positive welfare effects of markets) together, we get a measure of total welfare (or total surplus). Total welfare is a concept that long-term readers of this blog will have seen many times (most recently here). It is important for understanding the value that markets generate, and how policies or interventions in the market will affect the wellbeing of the buyers and sellers operating in the market.

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[*] Actually, my consumer surplus is likely to be even higher than $15.02. Since I was willing to pay at least $35 for the pair of sneakers, I was probably willing to pay more. I won't tell you how much more, just in case The Warehouse is listening. We're not at the stage where retailers are extensively using personalised pricing (see here for a related example), but I'm not taking any chances!