THEORY OF CONSUMER SURPLUS:
We discuss the basic concept of consumer surplus and its derivation. A consumer normally pays less for a commodity than the maximum amount that she would be willing to pay rather than forego its consumption. Consumer surplus therefore in crude sense is the difference between what consumer willing to pay and what she actually pays. Several measures of such consumer's surplus have been proposed. We will discus three of them. Attention is limited to a consideration of the good under investigation and a composite commodity called "money", with consumption quantities of q and M respectively. Let the distance OA in Figure represents the consumer's income. She achieves a tangency solution at point D on indifference curve I2. If she were unable to consume Q, she would be at A on the lower indifference curve I1. She would have to be given an income increment of AB dollars to restore her to indifference curve I2. This increment, called compensating income variation, is denoted by c, and provides a measure of consumer's surplus.
At the given prices, the consumer would be willing to forgo AC dollars of income rather than lose her opportunity to consume good Q. With income OC, her consumption is at E, which is on the same indifference curve as A. The amount corresponding to AC is called equivalent income variation and is denoted by e. It provides an alternative measure of consumer's surplus. A third measure is provided by the demand curve in Figure for the price-quantity combination p0q0. It equals the area ABp0, which is the difference between the area lying under the demand curve OABp0 and the consumer's expenditure Op0Bq0, and is denoted by s.
It can be shown that c ≥ s ≥ e. The strict inequalities hold for the case pictured in Figure as a consequence of the income effect. If the consumer were to pay more to consume the good, her demand would decline because of her lower effective income, and the area under the demand curve would exceed the amount that she would pay rather than forego consumption of the good. Figure depicts a case in which the income effect is zero throughout. A perpendicular such as the line through D and E connects points with the same marginal rate of substitution. The indifference curves are "parallel" with a constant vertical distance between a pair of indifference curves. In this case AB=AC and the three measures of consumer's surplus are the same.