Consumer’s Surplus

The concept of consumer surplus is derived from the law of diminishing marginal utility. As per the law , as we purchase more of a commodity, its marginal utility reduces. Since the price is fixed , for all units of the goods we purchase, we get extra utility. This extra utility is consumer surplus.

Consumer surplus is an economic measurement of consumer benefits. Consumer surplus happens when the price that consumers pay for a product or service is less than the price they're willing to pay. It's a measure of the additional benefit that consumers receive because they're paying less for something than what they were willing to pay.

A consumer surplus occurs when the consumer is willing to pay more for a given product than the current market price.

The Basics of a Consumer Surplus:

The concept of consumer surplus was developed in 1844 to measure the social benefits of public goods such as national highways, canals, and bridges. It has been an important tool in the field of welfare and the formulation of tax policies by governments.

Consumer surplus is based on the economic theory of marginal utility, which is the additional satisfaction a consumer gains from one more unit of a good or service. The utility a good or service provides varies from individual to individual based on their personal preference. Typically, the more of a good or service that consumers have, the less they're willing to spend for more of it, due to the diminishing marginal utility or additional benefit they receive.

Assumptions of the Consumer Surplus Theory:

1. Utility is a measurable entity

      The consumer surplus theory suggests that the value of utility can be measured. Under Marshallian economics, utility can be expressed as a number. For example, the utility derived from an apple is 15 units.

2. No substitutes available

      There are no available substitutes for any commodity under consideration.

3. Ceteris Paribus

     It states that customers’ tastes, preferences, and income do not change.

4. Marginal utility of money remains constant

It states that the utility derived from the income of a consumer is constant. That is, any change in the amount of money of a consumer does not change the amount of utility they derive from it. It is required because without it, money cannot be used to measure utility.

5. Law of diminishing marginal utility

It states that the more a product or service is consumed, the lower the marginal utility is derived from consuming each extra unit.

6. Independent marginal utility

The marginal utility derived from the product being consumed is not affected by the marginal utility derived from consuming similar goods or services. For example, if you consumed orange juice, the utility derived from it is not affected by the utility derived from apple juice.

Alfred Marshall, British Economist defines consumer’s surplus as follows: “Excess of the price that a consumer would be willing to pay rather than go without a commodity over that which he actually pays.”

Hence, Consumer’s Surplus = The price a consumer is ready to pay – The price he actually pays

Further, the consumer is in equilibrium when the marginal utility is equal to the price. That is, he purchases those many numbers of units of a good at which the marginal utility is equal to the price. Now, the price is fixed for all units. Hence, he gets a surplus for all units except the one at the margin. This extra utility is consumer surplus.

Let us take a look at an example of consumer surplus

From the table above, we see that as the consumption increase from 1 to 2 units, the marginal utility falls from 30 to 28. This diminishes further as he increases consumption. Now,

• Marginal utility is the price the consumer is willing to pay for that unit.
• The actual price of the unit is fixed.

Therefore, the consumer enjoys a surplus on all purchases until the sixth unit. When he buys the sixth unit, he is in equilibrium, since the price he is willing to pay is equal to the actual price of the unit.

Graphical Representation

The concept of consumer surplus is illustrated graphically as follows:

In the figure, you can see that the X-axis measures the amount of commodity, while the Y-axis measures the price and marginal utility. Further, MU represents the marginal utility curve, sloping downwards. This indicates that as the marginal utility falls, the consumer purchases more units of the commodity and vice-versa.

Next, if OP is the price of a unit of the commodity, the consumer is in equilibrium only when he purchases OQ units. In other words, when marginal utility is equal to the price OP.

Further, the Qth unit does not yield any surplus since the price and marginal utility is equal. However, for the purchase of all units before the Qth unit, the marginal utility is greater than the price, offering a surplus to the consumer.

In Fig. 2 above, the total utility is equal to the area under the marginal utility curve  up to point Q (ODRQ). However, for price = OP, the consumer pays OPRQ. Hence, he derives extra utility equal to DPR which is consumer surplus.

Limitations

1. It is difficult to measure the marginal utilities of different units of a commodity consumed by a person. Hence, the precise measurement of consumer’s surplus is not possible.

2. For necessary goods, the marginal utilities of the first few units are infinitely large. Hence the consumer’s surplus is infinite for such goods.

3. The availability of substitutes also affects the consumer’s surplus.

4. Deriving the utility scale for prestigious goods like diamonds is very difficult.

5. We cannot measure the consumer’s surplus in terms of money. This is because the marginal utility of money changes as a consumer makes purchases and his stock of money diminishes.

6. This concept is acceptable only on the assumption that we can measure utility in terms of money or otherwise. Many modern economists are against the concept.

Measuring Consumer Surplus with a Demand Curve:

The demand curve  is a graphic representation used to calculate consumer surplus. It shows the relationship between the price of a product and the quantity of the product demanded at that price, with price drawn on the y-axis of the graph and quantity demanded , drawn on the x-axis. Because of the law of diminishing marginal utility, the demand curve is downward sloping.

Consumer surplus is measured as the area below the downward-sloping demand curve, or the amount a consumer is willing to spend for given quantities of a good, and above the actual market price of the good, depicted with a horizontal line drawn between the y-axis and demand curve.

Consumer surplus can be calculated on either an individual or aggregate basis, depending on if the demand curve is individual or aggregated. Consumer surplus always increases as the price of a good falls and decreases as the price of a good rises.

3. The majority of demand curves in markets are assumed to be ownward sloping. When demand is inelastic (i.e. Ped<1), there is a greater potential consumer surplus because there are some buyers willing to pay a high price to continue consuming the product. Businesses often raise prices when demand is inelastic so that they can turn consumer surplus into producer surplus.

When there is a shift in the demand curve leading to a change in the equilibrium market price and quantity, then the level of consumer surplus will change too.

The price elasticity of demand (PED) is a measure that captures the responsiveness of a good’s quantity demanded to a change in its price. More specifically, it is the percentage change in quantity demanded in response to a one percent change in price when all other determinants of demand are held constant.

The formula for the coefficient of PED is:

The law of demand states that there is an inverse relationship between price and demand for a good. As a result, the PED coefficient is almost always negative. However, economists tend to ignore the sign in everyday use. Only goods that do not conform to the law of demand, such as Veblen and Giffen goods, have a positive PED.

The numerical values for the PED coefficient could range from zero to infinity. In general, the demand for a good is said to be inelastic (or relatively inelastic) when the PED is less than one (in absolute value): that is, changes in price have a less than proportional effect on the quantity of the good demanded. The demand for a good is said to be elastic (or relatively elastic) when its PED is greater than one. In this case, changes in price have a more than proportional effect on the quantity of a good demanded.

A PED coefficient equal to one indicates demand that is unit elastic; any change in price leads to an exactly proportional change in demand (i.e. a 1% reduction in demand would lead to a 1% reduction in price).

Consumer Surplus and Market Prices.