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Consumers Surplus: Meaning and Measurement

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Meaning of Consumer's Surplus


Consumers surplus is also known as buyers surplus. Prof. Boulding named it Buyers
surplus. Let us look at an example to understand the concept of consumers 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 the
commodity X does not have alternatives. When it comes to 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 consumers 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 is equal to $10. However, you are able to buy the commodity for $5.

Therefore, consumers surplus = total utility market price.

Hence, you could recognize consumers surplus in commodities that are highly useful and low priced.

Definition of consumers surplus

Prof. Samuelson defines consumers surplus as The gap between the total utility of a good and its total market
value is called consumers surplus. In the words of Hicks, Consumers 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 consumers surplus or buyers surplus:

Utility as a measurable entity

The theory of consumers surplus assumes that utility can be measured. Marshall in his cardinal utility theory
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.

Ceteris paribus

This assumption means that the customers income, tastes, preferences and fashion remain unchanged during
the analysis.

Marginal utility of money is constant

The theory of consumers 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 that is in the hands of customer does not affect
the marginal utility derived from it. This assumption is necessary because without it, money cannot perform as a
measuring rod.

Concept of diminishing marginal utility

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The theory of consumers surplus is based on the law of diminishing marginal utility. The law of diminishing
marginal utility claims that as you consumer 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, the utility derived from it 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 consumers 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 consumers surplus, Alfred
Marshalls method is still useful.

According to Alfred Marshall,

Consumers 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 consumers surplus for an individual:

Table 1

Units of Commodity Marginal Utility (Imaginary price) Market Price (cents) Consumer's Surplus

1 50 10 40

2 40 10 30

3 30 10 20

4 20 10 10

5 10 10 0

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Units of Commodity Marginal Utility (Imaginary price) Market Price (cents) Consumer's Surplus

Total = 5 units TU = 150 Total = 50 Total 100

Thus, consumers 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, consumers surplus is 100 (40 +30 + 20 +10).

Consumer's surplus for a market


The above example shows how to measure consumers surplus for an individual. Similarly, you could measure
consumers surplus for an entire market (group of individual consumers) with the help of market demand curve
and market price line.

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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 consumers surplus for the market.

Summation of Consumers Surplus


Summation of consumers surplus gives consumers surplus. Consumers 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 consumers surplus for a market (explained above).
While analyzing consumers surplus for a market, we consider market demand curve and market price line.
However, in consumers surplus, we add the consumers 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 consumers surplus. An inverse relationship means
that a decline in market price increases consumers surplus and vice-versa.

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In figure 3, when the market price for the commodity under consideration is OP, the areas Q and R are
consumers surplus. If there is an increase an increase in the market price (OP1), the area Q will represent
consumers surplus. Note that there is a loss of consumers surplus equivalent to area R. When the price
decreases (OP2), consumers surplus increases (area Q + area R + area S).

J.R. Hicks Method of Measuring Consumers Surplus


Prof. J.R. Hicks and R.G.D. Allen have introduced indifference curve approach to measure consumers surplus.
Prof. J.R. Hicks and R.G.D. Allen are unable to accept the assumptions suggested by Marshall in his version of
measuring consumers surplus. According to these economists, the assumptions are impracticable and
unrealistic.

According to Prof. J.R. Hicks and R.G.D. Allen,

1. Marginal utility of money is not constant. If the stock of money decreases, the marginal utility of money will
increase.
2. Utility is not a measurable entity but subject in nature. Hence, it cannot be measured in cardinal numbers.
3. Utility derived from a unit of a commodity is not independent. Instead, utility is related to previous units
consumed.

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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
consumers surplus.

The Hicks version of measuring consumers surplus attains results without Marshalls doubtful assumption.
Hence, Hicks version is considered to be superior to that of Marshalls.

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