Price Elasticity of Demand

We’ve discovered an important feature of the demand curve. On the surface, a demand curve shows us the quantity demanded at different prices in the market, but

The demand curves also shows the marginal benefit of a good.

How much additional benefit we get from an extra unit of a good. And so we can use our demand curve to analyse how much benefit consumers will receive in a market and how their benefit will be affected when the economy changes: like when the government announced a sugar tax to increase the price of fizzy drinks  like Coke and Pepsi; or when David

Cameron announced that tuition fees, the price of university, would be tripling from £3000 to £9000.

To see this we’ve got the supply and demand diagram for the chocolate cupcake market! 

As we can see the equilibrium price is £5… and the equilibrium quantity is 5 – so 5 chocolate cupcakes are being produced and consumed.

But of course some people in this market will be willing to pay much more than £5, for instance, 

If we move up from our quantity of one, we can see that this first consumer is willing to pay £9 for her chocolate cupcake, in other words she gets £9 of benefit from this first cupcake.

Well she actually pays just £5, the equilibrium price, so after paying for her cupcake how much benefit is she left with, in other words, 

She ends up with £4 of surplus benefit, she receives £9 of benefit from eating the cupcake, but has to to pay £5 for it, so she ends up with £4 of surplus benefit. 

And we can show that on our diagram, she’s willing to pay £9 she gets £9 of benefit, but she only pays £5 so her surplus benefit is this £4 vertical gap.

What about our second consumer? 

He gets £8 of benefit from the his chocolate cupcake because that’s the most he’s willing to pay.. but he actually pays again just £5, the equilibrium price, so £8 minus £5, gives us his £3 of surplus benefit shown by this vertical line…

Same as before, third person, she’s willing to pay £7, actually pays just £5, so she must receive £7 of benefit, take away £5, so £2 surplus benefit – which again can be seen graphically

And same with the fourth and so on.

But in real life we don’t just have 1, 2, 3, 4, 5 consumers in a market… we might have 1000 2000 3000 4000 5000 consumers, so we need to include all of these lines in between for all the consumers in between… all the way up to our equilibrium quantity – remember no one consumes beyond this quantity, it’s the equilibrium quantity in the market! That’s how much is bought and sold.

And if we kept on adding lines we would end up with this shaded triangle here which shows you the total benefit all of our consumers get from buying chocolate cupcakes at £5.

And we call this triangle, consumer surplus! Which is just how much benefit consumers get, and we define consumer surplus as the difference between what consumers are willing to pay and what they actually pay.

And you can see how that matches what we’ve done here on our diagram.

The demand curve tells us what consumers are willing to pay and the equilibrium price is what they actually pay… and all of these lines in between show us the difference between willing to pay and actually pay!

So in summary, consumer surplus measures how much benefit consumers get. It’s defined as the…

It’s defined as the difference between what consumers are willing to pay and what they actually pay. What they’re willing to pay which is represented by our demand curve, and they actually pay the equilibrium price! 

And as we look at the difference between the two for the thousands or millions of consumers in a market in the real world, we end up with this triangle of consumer surplus here!