Let us make an in-depth study of Consumer’s Surplus. After reading this article you will learn about: 1. Concept of Consumer’s Surplus 2. Measurement of Consumer’s Surplus 3. Limitations 4. Importance.
Concept of Consumer’s Surplus:
The concept of ‘consumer’s surplus’ was coined in the literature by A. Marshall. However, the idea of this surplus was explored by a French economist, Dupit, in his study of the benefits arising from the construction of public utilities, like roads and bridges.
The concept of consumer’s surplus is derived from the law of diminishing marginal utility. A consumer receives more than he pays for. The excess of benefits from the consumption of a commodity over the sacrifice made in terms of price paid for the commodity is called consumer’s surplus.
The difference between the price that the consumer is willing to pay and the price that the consumer actually pays for the commodity is surplus of utility. According to Prof. Tausig, consumer’s surplus is the difference between potential price and actual price. Suppose a consumer is ready to spend Rs. 50 for having a cinema ticket.
If the price of a ticket is just Rs. 42 for a cinema show, he enjoys surplus to the extent of Rs. 8. The consumer now gets a ‘bonus’ because the value he places on the cinema ticket is higher than the price he has to pay for it. This ‘bonus’ is called consumer’s surplus.
Thus, consumer’s surplus is the difference between the money value of the total utility received and the quantity of goods purchased multiplied by its price, i.e., consumer’s surplus = TU – (number of goods purchased x price).
Marshall explained consumer’s surplus in this way:
“The excess of price which a consumer would be willing to pay rather than go without the commodity, over that which he actually does pay, is the measure of this surplus satisfaction. Assuming a cardinal measurement of utility and the constancy of marginal utility of money, Marshall thinks this surplus as a money measure of excess satisfaction which the consumer gets from his purchases.”
Measurement of Consumer’s Surplus:
This idea of surplus satisfaction can be represented diagrammatically. In Fig. 2.14, we measure quantity of good X purchased on the horizontal axis and price as well as marginal utility on the vertical axis. DD1 is the demand curve for good X. The consumer buys OQ at a price OP.
The total utility that the consumer obtains from OQ units of good X is the area under the demand curve, i.e., ODMQ. This means that the consumer is ready to pay the sum ODMQ.
But he actually pays OPMQ (i.e., price x number of goods purchased). Thus, the consumer gets a surplus or benefit to the tune of DPM—the shaded area. A fall in price enables a consumer to enjoy greater surplus. On the other hand, consumer’s surplus gets reduced when price of the commodity rises.
Limitations of the Consumer’s Surplus:
Consumer’s surplus plays a great role in welfare economics. However, the concept is fraught with various difficulties since its measurement involves great complications.
The main limitations of the concept are:
Firstly, utility is not amenable to measurement. This concept largely depends on the measurability of utility. Utility, above all, varies from person to person, from commodity to commodity. Since tastes and preferences vary from person to person, one cannot measure surplus accurately.
Again, for conventional necessary goods (e.g., salt) it is not possible to measure excess benefit since the consumer may spend his entire income rather than go without it.
Under the circumstance, consumer’s surplus may be infinite. One even encounters problem in measuring surplus derived from substitute goods. Finally, goods having snob appeal may have lower degree of satisfaction or surplus when their prices fall.
Secondly, Marshall assumed diminishing marginal utility for commodity and constant marginal utility of money to explain his concept of surplus. But we know that, like commodities, marginal utility also has the tendency to decline when the stock of money increases.
In view of these problems associated with this concept, Prof. Nicholson argues that the consumer’s surplus is illusory, imaginary and hypothetical.
Utility or Importance of the Consumer’s Surplus:
Though the difficulties are great, the concept is not totally useless.
It has some theoretical and practical importance:
(i) Theoretical Utility:
The concept is useful while making a distinction between value-in-use and value-in- exchange. Value-in-use is represented by potential price while value-in- exchange refers to actual price of a commodity. The utility of a commodity depends on its value-in-use while price of a commodity depends upon its value- in-exchange. Thus, value-in-use and value-in-exchange may differ when the concept of surplus is invoked.
Secondly, this concept may be used in comparing welfare levels of two groups of people. People living in cities enjoy greater surplus in the form of entertainment and educational attainment than people living in rural areas. Marshall calls these advantages derived from conjunctural circumstances.
(ii) Practical Utility:
The concept has a practical importance to a finance minister. A tax imposed on a commodity raises its price and, thus, the surplus that the consumer gets declines. So the finance minister must take into account the extent of surplus while imposing taxes to earn more revenue.
He must make a trade-off between surplus reduction and revenue increase at the time of imposing taxes. A tax that reduces surplus to a smaller degree but raises revenue of the government to a larger amount is said to be a desirable tax. Similarly, while granting bounties and subsidies, the opposite will happen.
A monopolist, while fixing the price of his product, must be aware of the surplus that the consumer gets. If he raises the price of his product arbitrarily, consumers will be dissatisfied and, therefore, the consumer’s surplus will decline. Thus, a monopolist always fixes price of his product in such a way that the surplus enjoyed by the consumer does not reduce to zero.
Gains from international trade can also be measured with the aid of the concept of consumer’s surplus.
Finally, a correct social decision can also be made by using the concept of consumer’s surplus. It can be used to study the benefits arising from the construction of public facilities such as roads and bridges.