Course Title: Public Sector Economics

Course Code: Eco 314

Section: 1
Term Paper Topic: “User Cost and Producer Surplus”

Submitted to:
Professor, Advisor, Coordinator
Department of Economics

Date of Submission: 10th April, 2023

 User Cost

User cost is a term used in economics to describe the cost that consumers incur when they use
a good or service. It includes not only the monetary price of the good or service, but also any
additional costs that are associated with its use, such as time and effort. Understanding user
cost is important for both businesses and consumers, as it can impact purchasing decisions and
the overall efficiency of markets.
For example, if a consumer chooses to purchase a new car that costs 10,00,000 taka, the user
cost of that car includes not only the purchase price but also any ongoing costs associated with
using it, such as fuel, insurance, and maintenance. The opportunity cost of purchasing the car
would be the value of the next-best alternative use of the 10,00,000 taka, such as investing it in
a stock or bond.
Similarly, if a business purchases a piece of machinery, the user cost would include not only the
purchase price of the machine but also any costs associated with operating and maintaining it,
such as electricity bills, replacement parts, and repairs.

User cost can vary depending on a number of factors, such as the type of item being purchased,
the level of maintenance required, and the frequency of use. In general, items that require
more frequent maintenance or have a shorter useful life tend to have higher user costs.

User cost is an important concept in economics because it helps individuals and businesses
make informed decisions about whether or not to use a particular good or service based on the
total cost involved. In addition, user cost can also have important implications for businesses
and policymakers, as it can affect the demand for goods and services, as well as the overall
economic welfare of a society.
For example, if the user cost of a product is too high, it may deter consumers from purchasing
it, even if they find the product desirable.
User cost and quantity demanded are inversely related. If price goes up quantity demanded will
go down and if price goes down quantity demanded will go up.

Suppose there is a bridge (public good) which is toll free. The bridge capacity is at Qc level
which is large enough. When Price is zero the quantity demanded of the bridge is Qm. If
government starts charging toll at P1 for using the bridge, some people will stop using the
bridge and the quantity demanded will decrease at point Qe. If further government increases
the toll at P2 for using the bridge, more people will stop using the bridge and the quantity
demanded will decrease at point Q2.
Similarly, if the government decreases the toll from P2 to P1 the quantity demanded will
increase from Q2 to Q1.

One of the most important components of user cost is the monetary price of the good or
service. This is the amount of money that a consumer must pay in order to purchase the item.
In most cases, the price of a good or service will reflect the cost of production, including labor,
materials, and overhead. However, prices can also be influenced by external factors such as
taxes, subsidies, and market competition. Consumers must consider the price of a good or
service when deciding whether or not to purchase it, and may compare the price to alternative
products in order to make an informed decision.

Another important component of user cost is the time and effort required to use the good or
service. For example, a consumer may have to spend time learning how to use a new software
program, or may need to travel to a specific location in order to access a particular service.
These costs are known as "search costs" and can be a significant barrier to consumption,
especially for goods or services that are complex or difficult to use. Similarly, "transaction costs"
such as the time and effort required to make a purchase or negotiate a contract can also add to
the user cost of a good or service.

In addition to search and transaction costs, there are also "maintenance costs" associated with
using a good or service. These can include the cost of repairs, upgrades, or ongoing
maintenance, and are an important consideration for consumers when making purchasing
decisions. For example, a consumer may choose to purchase a cheaper product initially, but
incur higher maintenance costs over time. Alternatively, they may choose to invest in a higher-
quality product that requires less maintenance in order to minimize long-term costs.

One final component of user cost is the opportunity cost of using a particular good or service.
This refers to the cost of forgoing alternative uses of time, money, or resources in order to use a
specific product. For example, a consumer may choose to spend money on a vacation rather
than purchasing a new car, or may choose to work longer hours in order to earn more money.
Understanding opportunity cost is important for both businesses and consumers, as it can
impact the perceived value of a product and the overall efficiency of markets.

In conclusion, understanding the concept of user cost can help individuals and businesses make
more informed decisions when making purchases, as it provides a more accurate assessment of
the true cost of owning and using an item over time.

Consumer surplus
Consumer surplus is a term used in economics to describe the difference between the
maximum price a consumer is willing to pay for a good or service and the actual price they pay
in the market. Essentially, consumer surplus represents the value that a consumer receives
from a good or service that exceeds the monetary cost of purchasing it.

To understand consumer surplus, it is important to first consider the concept of willingness to

pay. This refers to the maximum amount of money that a consumer is willing to spend on a
particular good or service. Willingness to pay can vary widely depending on the individual
consumer and their personal preferences, but it is generally influenced by factors such as
income, availability of substitutes, and perceived value.

In a competitive market, the price of a good or service is determined by the interaction of

supply and demand. Producers will typically set a price based on the costs of production and
the level of demand for the product. Consumers who are willing to pay the market price will
purchase the product, while those who are not willing to pay that price will not.

Consumer surplus is created when a consumer is able to purchase a good or service for less
than their maximum willingness to pay. For example, if a consumer is willing to pay 100 taka for
a particular product, but the market price is only 80 taka, then the consumer will receive a
consumer surplus of 20 taka. This surplus represents the additional value that the consumer
receives from the product beyond the monetary cost of purchasing it.

Price of a product and consumer surplus is inversely related. So, whenever there is an increase
in price of good, number of consumers does fall. In addition, the consumer surplus to the users
reduced. Similarly, whenever there is a decrease in price of good, the consumer surplus to the
users increase.
Here, the maximum willingness to pay for the product is P'. So, if there is no price for the
product, quantity demanded of that product is Q' and the Consumer surplus is triangle ∆P'OQ' .
The moment we interviews the price of the product consumer have to pay now OP 0. And the
Consumer surplus is reduced and now the consumer surplus is triangle ∆P0P'a. When the price
of the product is increased from P0 to P1 the consumer surplus is reduced again and it becomes
triangle ∆P1P'b. If the price of the product increase further from P1 to P2 the consumer surplus is
reduced again and it becomes triangle ∆P2P'c. We can see whenever there is an increase in
product price the consumer surplus is reduced. But as long as the price is below than P' there
will be some consumer surplus as P' is the price which is the maximum willing to pay for the
product. If we think about the opposite scenario, whenever there is a decrease in price of good,
the consumer surplus to the users increase.

Consumer surplus can have a significant impact on consumer behavior and market efficiency.
Consumers who receive a surplus are likely to be more satisfied with their purchase and may be
more likely to purchase the product again in the future. Additionally, consumer surplus can lead
to increased competition and innovation in the market, as producers seek to capture a larger
share of the surplus by offering higher quality products or lower prices.

From a producer's perspective, understanding consumer surplus is important for setting

effective pricing strategies. Producers may be able to capture a portion of the consumer surplus
by setting a higher price for the product, but they must also be mindful of the impact this may
have on consumer demand. In some cases, setting a lower price may be more effective in
capturing a larger share of the consumer surplus and increasing overall sales.

Overall, consumer surplus is an important concept in economics that highlights the value that
consumers receive from a good or service beyond the monetary cost of purchasing it. By
understanding the factors that influence consumer willingness to pay and the impact of market
prices on consumer behavior, producers can develop effective pricing strategies that maximize
both their own profits and the value received by consumers.
 Relation between ‘User Cost’ and ‘Consumer Surplus’

User cost and consumer surplus are two important economic concepts that are closely related
to each other.

In a perfectly competitive market, the equilibrium price is determined by the intersection of the
demand and supply curves. At this price, the consumer surplus and producer surplus (the
benefit that producers receive from participating in the market) are maximized. This is because
at the equilibrium price, the market is in balance, and there is no excess demand or supply. As a
result, both consumers and producers are able to obtain the maximum possible benefit from
participating in the market.

When the market price is lower than the equilibrium price, there is excess demand for the
good, and consumers experience a shortage. In this situation, consumer surplus is reduced, but
producer surplus is increased because producers can charge a higher price. The increase in
producer surplus is due to the fact that producers are able to charge a price that is higher than
the cost of producing the good. This results in a larger gap between the price that producers
receive and the cost of production, which increases the producer surplus. At the same time, the
reduction in consumer surplus is due to the fact that consumers are forced to pay a higher price
for the good.

Conversely, if the market price is higher than the equilibrium price, there is excess supply, and
consumers experience a surplus while producers experience a reduction in producer surplus. In
this situation, the consumer surplus is increased because consumers are able to purchase the
good at a lower price. As a result, the relationship between user cost and consumer surplus is
positive, with changes in the price affecting both concepts in the same direction.
Suppose there is a public good which means it is non-exclusive and non-rival. Road is a public
good and 1000 or more people can use it at a time without paying any price.

If government doesn’t charge any price for using the road the entire triangle area is the
consumer surplus which is the gap between what the consumer is willing to pay and what s/he
is actually paying. And the consumer surplus is area is triangle ∆OQ SP’.
Now, suppose government decided to charge for using the road (Toll). The moment
government starts charging the toll (User Cost) consumer have to pay now OP which is the price
of the toll. The good was universal but now forced to pay a part of the price/cost but still there
is a gap between P to P'. Here, government gets a revenue area = OQRP. This is the revenue
government collect from the user cost of using the road and will use for undertaking public
sector project. The consumer surplus is reduced and now consumer surplus is PRP’. It is certain
whenever a user cost (however small it is) is used number of users do fall. In addition the
consumer surplus to the users reduces and there is a part which is completely loss (nobody
gains) and this is called dead weight loss. Whenever there is taxation (user cost) there is dead
weight loss for the society, which is never recovered. Here the area of dead weight loss is
triangle ∆QRQS.
The relationship between user cost and consumer surplus has important implications for
market efficiency. When the market is in equilibrium, consumer surplus is maximized, and the
market is said to be efficient. However, when the market is not in equilibrium, there is a loss of
efficiency, as some consumers are unable to obtain the good at the market price.

In addition, the relationship between user cost and consumer surplus can help to explain
consumer behavior. Consumers are more likely to purchase a good or service when the user
cost is low and the consumer surplus is high. This is because consumers are more likely to
perceive the purchase as a good deal or a good value for their money. Conversely, consumers
are less likely to purchase a good or service when the user cost is high and the consumer
surplus is low. This is because consumers are more likely to perceive the purchase as expensive
or not worth the cost.

In conclusion, user cost and consumer surplus are two important economic concepts that are
closely related to each other. A low user cost increases consumer surplus, while a high user cost
reduces it. Changes in the market price also affect both concepts in the same direction.
Understanding the relationship between user cost and consumer surplus is essential for
predicting consumer behavior and assessing market efficiency.

Reference:
 JOSEPH STIGLITZ Economics of the public sector, third edition
 Public Finance and The Price System by Edgar K. Browning and Jacquelene M. Browning
 Lecture notes of Public Sector Economics given by Dr. Mohammed Farashuddin