Consumer Surplus

Consumer Surplus:

The doctrine of consumer surplus plays a vital role in modern economic analysis. This doctrine is very often attributed to Dr. Alfred Marshall. Actually, however, the concept of consumer surplus was first visualized by a French engineer-economist, Arsene Jules Dupuit, in 1844. As an engineer, he sought to measure the consumer surplus that would accrue to the people consequent upon the construction of a bridge across a river. His statement of the concept was, however, not only incomplete but also lacked scientific character. For example, he did not care to state clearly the various assumptions upon which the concept was based. It was left to Marshall to give not only a scientific status to the idea but also to fill in the existing gaps in the concept. Marshall gave the first version of the concept in 1879 in his Pure Theory of Domestic Values under the title of Consumer’s Rent. Later in his Principles of Economics, he developed it further and named it “Consumer’s Surplus”. Prof. Boulding has renamed it as “Buyer’s Surplus”.

Explanation of the Concept:

The law of diminishing marginal utility tells us that after a certain point, each successive unit one obtains of a commodity yields him less satisfaction than the preceding unit. Thus, if a person buys three units of a commodity at Rs. 1/- per unit, the first unit of the commodity yields him more satisfaction than the second unit, and the second unit yields him more satisfaction than the third. Since it is assumed that he would not have bought the third unit for $1 unless he had considered that it would yield him that amount of satisfaction, it can be argued that the first and the second units yielded him more than a dollar’s worth of satisfaction. This additional satisfaction that the consumer gets over the first two units may be called the consumer’s surplus. This concept is applicable not only to a multi-unit but also to a single-unit article. For example, if a person is willing to pay for an electric lamp $35, if necessary, which in fact, he buys for $30, it could be said that he obtains $5 worth of consumer surplus.

In actual life, when a person buys a commodity, his gain is represented by the utility (that he derives from the commodity) and the loss is indicated by the price that he pays for the commodity. The price paid by him also represents other commodities that could be purchased instead of buying the commodity in question. This price, therefore, indicates the utility that he foregoes in buying the present commodity, or this price represents the disutility that he suffers by purchasing this commodity. Every rational consumer compares the utility (gain) with the disutility of the price (loss) that he pays for the commodity. If his gain (of utility) is either equal to or greater than his loss (disutility), he will make the purchase of the commodity. In case, the gain (of utility) from the commodity is smaller than the loss (disutility), he will refuse to buy it. Normally, the consumer makes the purchase only when his utility is greater than the price he pays for the commodity. In other words, he buys the commodity only if he hopes to get a surplus of utility or satisfaction from it. This surplus utility or satisfaction is referred to as Consumer’s Surplus. The consumer’s surplus may thus be defined as the excess of utility obtained by the consumer over utility foregone or disutility suffered. It is measured by the difference between the maximum price which the consumer is willing to pay for a commodity rather than go without it and the price which he actually pays for it. In the words of Dr. Marshall, “The excess of price which a person would be willing to pay rather than go without the thing over that which he actually does pay is the economic measure of this surplus of satisfaction. It may be called consumer’s surplus.”

In real life, there are several things from which the consumer obtains surplus satisfaction or he secures from them greater satisfaction than what he has paid for. For example, cheaper commodities like salt, newspaper, sugar, electricity, or cheap transport yield substantial surplus satisfaction to the consumers. The volume of consumer surplus is larger in advanced countries where these essential commodities are available to consumers in abundance at cheap rates. The consumer surplus is the product of “opportunities” available to the consumers in a country. These “opportunities” are available to the people in advanced countries in a greater measure than to the people in underdeveloped and backward countries. The consumer’s surplus is entirely the product of “environments”. If the government of a country, for example, stops the printing of newspapers, the people of that country will definitely suffer a loss of consumer surplus. The sum of money which the people were spending on newspapers will now be spent on other commodities from which they will secure less utility. They were formerly spending this money on newspapers because from them they were securing greater utility than they would obtain from other commodities. The stoppage of the printing of newspapers, therefore, definitely reduces their consumer surplus. Likewise, if the government of the country imposes an excise duty on salt, its price will go up and consequently people’s consumers’ surplus from salt will be reduced. It is, thus, evident that the volume of consumer surplus enjoyed by an individual is not determined materially by his own actions. It is, on the contrary, the product of “opportunities”, “environments” and “conjunctures”. The consumer’s surplus may, therefore, be considered a social phenomenon, determined more by social than by personal causes.

Consumer Surplus on a Single-Unit Purchase:

It is not difficult to understand how the consumer’s surplus arises when the consumer purchase only one single unit of a commodity. Let us suppose that a person is willing to pay $600 for a particular brand of radio set rather than go without it. Actually, that radio set is being sold in the market for $400. Now the consumer’s surplus in this case will be $600 – $400 = $200.

Consumer Surplus on a Multi-unit Commodity:

Let us now take the case of a person who buys a number of units of the same commodity at a certain price. The price that he pays for all the units of the commodity actually measures the utility of the marginal unit or is equal to the marginal utility of the commodity. But on the earlier units (which may be called intra-marginal units), the consumer secures a surplus of utility over price. The sum of the surpluses which he enjoys on all the intra-marginal units constitutes the consumer’s surplus. Let us take now the case of a person whose marginal utility schedule for sugar is given below.

Let us now suppose that the market price for sugar is $3 per kg. In that case, the consumer will buy 5 kgs. of sugar. The reason being that at this purchase the price of sugar becomes equal to the marginal utility obtained by the consumer. In other words, there is perfect equality between price and utility at this purchase. But the consumer pays the same price of $3 for the intra-marginal units also. On the first four kilograms, therefore, the consumer enjoys a surplus utility measured by 7 + 5 + 3 + 1 = $16. The total consumer surplus enjoyed by the consumer then comes to $16. We can represent this situation with the help of a diagram as well.

In this Diagram, DD is the marginal utility curve of the consumer. It might as well be called his demand curve. QM is the price of the commodity and OM represents the quantity bought by the consumer. QM is also the marginal utility of the consumer. So when the consumer buys OM quantity, the price that he pays is equal to the marginal utility that he secures. Or there is a balance between price and utility when OM quantity is bought. But on earlier units, he enjoys a surplus of utility which is indicated in this diagram by DNQ. The total utility that he enjoys on OM quantity is shown by the area OMQD. But the total amount paid by him for OM quantity is indicated by the area OMQN. The difference between the two (OMQD – OMQN) is DNQ which may be called his consumer’s surplus.

There is an inverse relationship between consumer surplus and the price of the commodity. If the price of the commodity falls, the consumer surplus increases. On the contrary, if the price of the commodity rises, the consumer’s surplus diminishes. This is shown in the diagram.

In this diagram, DC is the demand curve of the consumer. When the price of the commodity is ON, the consumer’s surplus accruing to him is DNQ. When the price rises to ON₁, the consumer’s surplus diminishes to DN₁Q₁. When the price falls to ON₂, the consumer’s surplus increases to DN₂Q₂. This can be explained easily. When the price rises, the difference between what the consumer pays and what he was willing to pay is correspondingly reduced. So the volume of consumer surplus is also reduced. Similarly, a fall in price by enlarging the difference between what he pays and what he was willing to pay increases the volume of the consumer’s surplus.

Consumer Surplus in a Market:

Having explained the concept of consumer surplus with reference to an individual, we can extend its scope so as to cover the entire market. If we forget for the time being that the same sum of money represents different amounts of utility to different individuals, i.e., if we ignore the inter-personal difference in incomes, tastes, fashions, etc., we can measure the consumer surplus arising in the whole market by the simple process of adding together the consumer surpluses enjoyed by all the buyers individually. Just as the market demand curve is derived by aggregating the individual demand curves, in the same manner, the aggregate consumer surplus can be found out by adding together the individual consumer’s surpluses. The method to be followed is the same; only the individual demand curve is replaced by the market demand curve. The above diagram explaining the individual consumer’s surplus can also be used to show the market consumer’s surplus if we treat the individual demand curve as the market demand curve.

Assumptions of Consumer Surplus:

Dr. Marshall based the concept of consumer surplus on a number of assumptions which may be set forth below:

(1) In developing the concept, Marshall assumes that utility and satisfaction have a definite relationship with each other. Utility implies expected satisfaction, whereas satisfaction means actual, realized satisfaction. Very often, there is a difference between the utility and satisfaction of a commodity. The commodity may appear to have a high degree of utility when it is bought by the individual consumer, but on actual consumption, it may yield satisfaction much less than what was expected. Marshall assumes that there is a definite relationship between expected satisfaction and realized satisfaction. Though Marshall does not explicitly mention this assumption during his discussion of this concept, yet it underlies his entire theory of demand and is, therefore, a part and parcel of his doctrine of consumer surplus.

(2) Since consumer surplus is derived from the demand curve, it is subject to all those assumptions on which the demand curve is based. As we have already pointed out earlier, the main assumption that underlies the demand curve is that determinants of demand, other than price, do not change. Therefore, while measuring consumer surplus of the various quantities of a commodity, Marshall does take into account the price changes but excludes the other determinants of demand.

(3) The third assumption is that when an individual consumer buys a particular commodity, the marginal utility of money to him remains constant throughout the process of exchange. In other words, when he buys the commodity against money, his marginal utility from money is not reduced but remains constant throughout the process of exchange. This is indeed an important assumption and it underlies Marshall’s entire analysis of value. Marshall was obliged to make this assumption because without it he could not have compared the utility obtained from the commodity with the disutility incurred or the price paid for it. He even justified this assumption on the ground that an individual consumer’s expenditure on any one particular commodity at any time was so inconsiderable as to be only a very small part of his total expenditure. As such, the marginal utility of money could be easily assumed to be constant during the process of exchange.

(4) The fourth assumption underlying the concept of consumer surplus is that the utility of a commodity depends upon the quantity of that commodity alone. In other words, each commodity is to be treated as an independent commodity. The utility of tea, for example, is assumed to be determined by the quantity of tea alone, not by the quantities of other related products.

(5) Dr. Marshall also assumed that the commodity under consideration had no substitutes of any kind, or the commodity in question was absolutely independent of related commodities. This assumption appeared to him to be indispensable for the construction of the demand curve. Dr. Marshall even went to the extent of saying that even if a commodity had substitutes, those substitutes could be grouped together and treated as a single commodity.

(6) While estimating the consumer surplus for the entire market, Dr. Marshall assumed that differences of income, tastes, fashions, etc., did not exist among the purchasers. They could be considered canceled in view of the large number of purchasers in the market. This assumption was essential for Dr. Marshall because without it he could not have measured the volume of consumer surplus in the entire market.

Marshall’s concept of consumer surplus, thus, holds good only on the basis of these assumptions.