Sundaram holds a Master's degree in Economics and has worked in marketing, search engine indexing, banking, and research analysis.
Meaning of Consumer's Surplus
A consumer’s surplus is also known as a buyer’s surplus. Professor Boulding named it ‘Buyer’s surplus.’ Let us look at an example to understand the concept of consumer surplus. Suppose there is a commodity called ‘X’ in the market. You would like to buy commodity X, as you deem that the commodity is very useful.
The important point here is that commodity X does not have alternatives. When it comes to the price of the commodity, you are willing to pay $10. However, when you inquire in the market, the seller says that the price of the commodity is $5. Therefore, the difference between what you are willing to pay and the actual price ($10 - $5 = $5 in our example) is called consumer’s surplus.
You are willing to pay $10 for the commodity because you feel that the commodity is worth $10. It implies that the total utility derived from the commodity equals $10. However, you are able to buy the commodity for $5.
Therefore, consumer surplus = total utility – market price.
Hence, you could recognize consumers’ surplus in highly useful and low-priced commodities.
Definition of Consumer’s Surplus
Professor Samuelson defines consumer surplus as “The gap between the total utility of a good and its total market value is called consumer’s surplus.” In the words of Hicks, “Consumer’s surplus is the difference between the marginal valuation of a unit and the price which is actually paid for it.”
Assumptions of Consumer's Surplus Theory
The following assumptions base the theory of consumer’s surplus or buyer’s surplus:
Utility as a Measurable Entity
The theory of consumer surplus assumes that utility can be measured. In his cardinal utility theory, Marshall has assumed that utility is a measurable entity. He claims that utility can be measured in cardinal numbers (1, 2, 3…). The imaginary unit to measure utility is known as ‘util’. For instance, the utility derived from a banana is 15 utils, the utility derived from an apple is 10 utils, and so on.
No Alternative Commodities Available
The second important assumption is that the commodity under consideration does not have substitutes.
This assumption means that the customer’s income, tastes, preferences and fashion remain unchanged during the analysis.
Marginal Utility of Money Is Constant
The theory of consumer surplus further assumes that the utility derived from the money stock in the hands of the customer is constant. Any change in the quantity of money in the hands of the customer does not affect the marginal utility derived from it. This assumption is necessary because money cannot perform as a measuring rod without it.
Concept of Diminishing Marginal Utility
The theory of consumer surplus is based on the law of diminishing marginal utility. The law of diminishing marginal utility claims that as you consume more of a commodity, the marginal utility derived from it decreases eventually.
Independent Marginal Utility
This assumption means that marginal utility derived from the commodity under consideration is not influenced by the marginal utilities derived from other commodities. For instance, we are analyzing consumers’ surplus for oranges. Though an apple is a fruit, its utility does not affect the utility derived from oranges.
Measurement of consumer's surplus: The law of diminishing marginal utility approach
The law of diminishing marginal utility is the basis for the concept of consumer’s surplus. The law of diminishing marginal utility states that as you consume a particular commodity more and more, the utility derived from it keeps on decreasing. For a particular commodity, there exists only one price in a market. For instance, you buy 10 coconuts. The price of a coconut in the market is $10. You pay the same price for all the units you buy. You pay $10 for the first coconut. Obviously, you do not pay $20 for the second. At the same time, the utility you derive from each coconut may differ.
Although there are various sophisticated measurements to calculate the concept of consumer’s surplus, Alfred Marshall’s method is still useful.
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According to Alfred Marshall,
Consumer’s Surplus = Total Utility – (Price × Quantity)
Symbolically, C.S = TU – (P × Q)
Since TU = ∑MU,
C.S = ∑MU – (P × Q)
Where TU = Total Utility
MU = Marginal Utility
P = Price
Q = Quantity
∑ (Sigma) indicates the sum total.
Table 1 depicts the measurement of consumer’s surplus for an individual:
|Units of Commodity||Marginal Utility (Imaginary price)||Market Price (cents)||Consumer's Surplus|
Total = 5 units
TU = 150
Total = 50
Thus, consumer’s surplus = TU – (P × Q) = 150 – (10 × 5) = 150 – 50 = 100.
The following diagram supports the measurement in a better manner:
In figure 1, x-axis represents units of commodity, and y-axis denotes price. Each unit of the commodity has same market price. Hence, consumer’s surplus is 100 (40 +30 + 20 +10).
Consumer's surplus for a market
The above example shows how to measure consumer’s surplus for an individual. Similarly, you could measure consumer’s surplus for an entire market (group of individual consumers) with the help of market demand curve and market price line.
In figure 2, DD represents market demand curve. It shows the price that the market is willing to pay for the successive units of a commodity. The market offers lower prices for the successive units of the commodity because of the law of diminishing marginal utility. PB denotes market price line. PB is horizontal, which implies that the market price is same for all units of the commodity. The point E represents equilibrium position, where market demand curve intersects market price line. OQ represents the quantity of the commodity that the market purchases given the equilibrium position.
In figure 2, ODEQ represents the money the market is ready to spend for OQ units of commodity.
However, OPEQ is the actual amount spent by the market to acquire OQ units of commodity.
Hence, DPE is consumer’s surplus for the market.
Summation of Consumer’s Surplus
Summation of consumer’s surplus gives consumers’ surplus. Consumer’s surplus refers to the surplus enjoyed by an individual consumer. On the other hand, consumers’ surplus refers to surplus enjoyed by the society as a whole. Note that consumers’ surplus is different from the consumer’s surplus for a market (explained above). While analyzing consumer’s surplus for a market, we consider market demand curve and market price line. However, in consumers’ surplus, we add the consumer’s surplus enjoyed by all the consumers individually. Marshall claims that in this way, we can measure the total surplus enjoyed by the society as a whole. However, we need to assume that there are no differences in income, preferences, taste, fashion etc.
Market Price and Consumer's Surplus
There is an inverse relationship between market price and consumer’s surplus. An inverse relationship means that a decline in market price increases consumer’s surplus and vice-versa.
In figure 3, when the market price for the commodity under consideration is OP, the areas Q and R are consumer’s surplus. If there is an increase an increase in the market price (OP1), the area Q will represent consumer’s surplus. Note that there is a loss of consumer’s surplus equivalent to area R. When the price decreases (OP2), consumer’s surplus increases (area Q + area R + area S).
J.R. Hicks’ Method of Measuring Consumer’s Surplus
Prof. J.R. Hicks and R.G.D. Allen have introduced indifference curve approach to measure consumer’s surplus. Prof. J.R. Hicks and R.G.D. Allen are unable to accept the assumptions suggested by Marshall in his version of measuring consumer’s surplus. According to these economists, the assumptions are impracticable and unrealistic.
According to Prof. J.R. Hicks and R.G.D. Allen,
- Marginal utility of money is not constant. If the stock of money decreases, the marginal utility of money will increase.
- Utility is not a measurable entity but subject in nature. Hence, it cannot be measured in cardinal numbers.
- Utility derived from a unit of a commodity is not independent. Instead, utility is related to previous units consumed.
In figure 4, horizontal axis measures commodity A and vertical axis measures money income.
Assume that the consumer does not know the price of commodity A. This means that there is no price line or budget line to optimize his consumption. Therefore, he is on the combination S on indifference curve IC1. At point S, the consumer has ON quantity of commodity A and SN amount of money. This implies that the consumer has spent FS amount of money on ON quantity of commodity A.
Now assume that the consumer knows the price of commodity A. Hence, he can draw his price line or budget line (ML). With the price line (ML), the consumer realizes that he can shift to a higher indifference curve (IC2). Therefore, the new moves to the new equilibrium (point C), where the price line ML is tangent to the indifference curve IC2. At point C, the consumer has ON quantity of commodity A and NC amount of money. This implies that the consumer has spent FC amount of money on ON quantity of commodity A. Now the consumer has to spend only FC amount of money instead of FS to purchase ON quantity of commodity A. Therefore, CS is the consumer’s surplus.
The Hicks’ version of measuring consumer’s surplus attains results without Marshall’s doubtful assumption. Hence, Hicks’ version is considered to be superior to that of Marshall’s.
This content is accurate and true to the best of the author’s knowledge and is not meant to substitute for formal and individualized advice from a qualified professional.
© 2013 Sundaram Ponnusamy
NISHA on September 13, 2018:
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