Why is it important to know the consumer surplus well?
The bookish definition does not suffice to reply this question A clear understanding of the concept shall help you to take business decisions associated with value pricing, price-output setting and price discrimination under the umbrella of marketing strategies.
The excess of, which a customer wants to pay for a product/service, over what she pays constitutes consumer surplus. It means, it’s the difference between two price levels; the buyer’s willingness to pay and the market price. A few critical definitions are given below:
“Consumer surplus is defined as the difference between the consumers' willingness to pay for a commodity and the actual price paid by them” – Economic Times
“A consumer surplus occurs when the consumer is willing to pay more for a given product than the current market price” – Investopedia
“It is the amount above the actual price of a commodity a purchaser would pay in order not to go without the commodity” – Merriam Webster
It is is a triangular area in the diagram, bordered by the demand curve, the price axis, and the price level as shown in the figure:
You might be familiar with the term, “willingness to pay” in basic economics? It is the maximum amount that a buyer is ready to pay for a product/service.
Suppose you are an electronic gadgets manufacturer, you charge $30 for each headphone you manufacture, while a customer is willing to pay $40 for it. The customer gets $10 as consumer-surplus!
A layperson might wonder, why is that customer willing to pay $40, more than the market price?
Naturally, he likes it and values the headphone, more than the price you charge! He perceives, your product is worthy enough to spend $40 for it. You will find its further explanation through the concept of perceived value.
The consumer always like to buy the products/services if they think, they are getting a good deal on them and consumer-surplus is merely an economic measure of this satisfaction or welfare. Usually, it’s measured as total consumer-surplus. Consumer surplus is quite related to the demand curve for a product/service.
You charge $30 for each headphone you sale. Calculating consumer surplus is easy. The figure below will help you to calculate it quickly. You can calculate surplus for four headphones by the following method.
You might have studied the Pythagorean Theorem in your school days. You got to locate the triangle in the diagram. It is a triangular area in the picture, bordered by the demand curve, the price axis, and the price level.
The market price is $30; the $50 is the point of the amount above which no customer is willing to purchase headphone. You can get the height of the triangle by $50 - $30 = $20. The base is the number of headphones.
You get $40 as consumer-surplus after applying the simple Pythagorean theorem.
You can understand this concept by keeping in mind the demand function.
A change in the demand curve results in a change in the equilibrium market price and also the quantity demanded. It will cause a shift in surplus. Let’s analyze the diagrams below.
In the fig (1), the equilibrium market price rises to P2 from P1 after an increase in the demand from D1 to D along an increase in quantity from Q1 to Q2. The higher level of demand brings in more consumer-surplus shown in the pic by the additional yellow area.
Let’s say, with the help of technology up-gradation, you enable your firm to produce more headphones, with less cost. It is shown as an outward shift of supply curve, i.e., an increase in the supply from S1 to S2. As a result, the consumer surplus will increase, shown by additional yellow region as a rise in consumer-surplus.
Remember, there is a trade-off between consumer-surplus and the revenue you generate. A trade-off means, you have to give up one thing, to get the other, marginally. If you go for more revenue through an increase in the product price, the consumer-surplus (if it already exists), will decrease as a result.
So, you should be careful while setting the price and for deciding consumer-surplus. The magnitudes of both may result in either larger consumer surplus and revenue loss, or more income (in some cases) along the comparably weak position of your firm in terms competitors’ identical product prices.
In the 1960's, the economist Philip Kotler introduced the business world, a more efficient model of Product Levels. He suggested that a product should be valued through five levels. They are core benefit, generic product, expected product, augmented product and potential product.
For the sake keeping you on the topic track, I am not taking you to its details right now. Suppose you are a production manager for a firm or an entrepreneur. Think, how much the difference between your perception, and the perception of your customers about your product/service, matters!
As a manager of a production firm, you may value your product or service based on various factors, mostly on your calculations regarding the total cost associated with it. It may also include many other factors depending on your business strategy and market conditions.
On the other hand, customers perceive the value of your product through several different factors like core benefit, branding, quality, color, style, customer care, delivery, warranty etc. They will pay you if they think their money is worth spend the product/service. Of course the gender, age group, lifestyle, profession etc. of your customers may also influence their perception regarding your product/service a
Simply, the perceived value is the worth that customer see in a product. You may sale your product to customers, much more than what it actually costs you, because of its perception in the eyes of customers’ mind. If you are, unfortunately, a bad marketer the customers’ perception of the value may be less than what the actual value of the product is.
Try to enhance the image of your product in customers’ mind using various marketing strategies. They would feel a considerable consumer surplus. Just think about your customer buzzing around in his/her social circle, saying “Wow! These headphones are so amazing, soft grip, surround sound, easy volume control, noise free mic and you know what? They cost only $30”
All of your strategies and tactics of creating or improving positive perception about your products/services in customers’ mind, may increase demand level, resulting in more consumer surplus!