Consumer Surplus

1. Consumer Surplus

2. Introduction
• The essence of the concept of consumer’s surplus is that a consumer
derives extra satisfaction from the purchases he daily makes over the
price he actually pays for them.
• It has been found that people are prepared to pay more price for the
goods than they actually pay for them. This extra satisfaction which
the consumers obtain from buying a good has been called consumer
surplus.
• The amount of money which a person is willing to pay for a good
indicates the amount of utility he derives from that good; the greater
the amount of money he is willing to pay, the greater the utility he
obtains from it.

3. Consumer’s surplus = What a consumer is willing to pay minus what he
actually pays = ∑ Marginal utility – (Price x Number of units of a
commodity purchased)
• The concept of consumer surplus is derived from the law of
diminishing marginal utility. As we purchase more units of a good, its
marginal utility goes on diminishing. It is because of the diminishing
marginal utility that consumer’s willingness to pay for additional units
of a commodity declines as he has more units of the commodity.

4. Marshall’s Measure of Consumer Surplus
• Consumer surplus measures extra utility or satisfaction which a
consumer obtains from the consumption of a certain amount of a
commodity over and above the utility of its market value.
• Thus the total utility obtained from consuming water is immense
while its market value is negligible.
• Marshall tried to obtain the monetary measure of this surplus, that is,
how many rupees this surplus of utility is worth to the consumer.
• It is the monetary value of this surplus that Marshall called consumer
surplus.

5. To determine this monetary measure of consumer surplus we are
required to measure two things.
• First, the total utility in terms of money that a consumer expects to
get from the consumption of a certain amount of a commodity.
• Second, the total market value of the amount of commodity
consumed by him.

6. Measurement of Consumer Surplus as an Area
under the Demand Curve
• If we assume that the commodity is perfectly divisible, which is
usually made in economic theory, the consumer surplus can be
represented by an area under the demand curve.
• DD’ is the demand or marginal utility curve which is sloping
downward, indicating that as the consumer buys more units of the
commodity falls, marginal utility of the additional units of the
commodity. As said above, marginal utility shows the price which a
person is willing to pay for the different units rather than go without
them.

7. • If OP is the price that prevails in the market, then the consumer will
be in equilibrium when he buys OM units of the commodity, since at
OM units, marginal utility from a unit of the commodity is equal to
the given price OP.
• The Mth unit of the commodity does not yield any consumer’s
surplus to the consumer since this is the last unit purchased and for
this price paid is equal to the marginal utility which indicates the price
that he is prepared to pay rather than go without it.
• But for the intra-marginal units i.e., units before Mth unit, marginal
utility is greater than the price and. therefore, these units yield
consumer’s surplus to the consumer. The total utility of a certain
quantity of a commodity to a consumer can be known by summing up
the marginal utilities of the various units purchased.

8. • If market price of the commodity rises
above OP, the consumer will buy fewer
units of the commodity than OM. As a
result, consumer’s surplus obtained by him
from his purchase will decline. On the
other hand, if price falls below OP, the
consumer will be in equilibrium when he is
purchasing more units of the commodity
than OM.
• As a result of this, the consumer’s surplus
will increase. Thus, given the marginal
utility curve of the consumer, the higher
the price, the smaller the consumer’s
surplus and the lower the price, the greater
the consumer’s surplus.

9. Measurement of Consumer’s Surplus through
Indifference Curve Analysis
• Economists like Hicks and Allen have expressed the view that utility is
a subjective and psychic entity and, therefore, it cannot be cardinally
measured. They further point out that marginal utility of money does
not remain constant with the rise and fall in real income of the
consumer following the changes in price of a commodity.
• The implication of Marshallian assumption of constant marginal utility
of money is that he neglects the income effect of the price change.
But in some cases income effect of the price change is very significant
and cannot be ignored.

10. • . In Fig. 14.4, we have measured the quantity of commodity X along
the X-axis, and money along the Y-axis. It is worth noting that money
represents other goods except the commodity X.

11. • Suppose, a consumer has OM amount of money which he can spend on the commodity X and the
remaining amount on other goods. The indifference curve IC1 touches the point M indicating
thereby that all combinations of money and commodity represented on the indifference curve
IC1 give the same satisfaction to the consumer as OM amount of money.
• For example, take combination R on an indifference curve IC1. It follows that OA amount of com-
modity X and OS amount of money will give the same satisfaction to the consumer as OM amount
of money because both M and R combinations lie on the same indifference curve IC1.
• In other words, it means that the consumer is willing to pay MS amount of money for OA amount
of the commodity X. It is thus clear that, given the scale of preferences of the consumer, he
derives the same satisfaction from OA amount of the commodity X as from MS amount of money.
In other words, he is prepared to give up MS (or FR) for OA amount of commodity X.
• Now, suppose that the price of commodity X in the market is such that we get the budget line ML
(price of X is equal to OM/OL). We know from out analysis of consumer’s equilibrium that
consumer is in equilibrium where the given budget line is tangent to an indifference curve. It will
be seen from Fig. 14.4 that the budget line ML is tangent to the indifference curve IC2 at point H,
where the consumer is having OA amount of commodity X and OT amount of money.
• Thus, given the market price of the commodity X, the consumer has actually spent MT amount of
money for acquiring OA amount of commodity X. But, as mentioned above, he was prepared to
forego MS (or FR) amount of money for having OA amount of X.
• Therefore, the consumer actually pays TS or HR less amount of money than he is prepared to pay
for OA amount of the commodity X rather than go without it. Thus, TS or HR is the amount of
consumer’s surplus which the consumer derives from purchasing OA amount of the commodity.

12. Uses and Applications of Consumer Surplus
• Explaining Value Paradox (Water-Diamond Paradox)

13. • One of the most famous puzzles in economic theory is why diamonds are more expensive than water. Water is essential for life; it is so useful that without its consumption one
cannot live or survive. On the other hand, diamonds, though attractive and beautiful, satisfy less important human needs than water.
• Then, how it can be that in the market a less useful commodity like diamond is so expensive and a highly useful commodity as water is very cheap. Some thinkers in the past
therefore complained that something was wrong with the market system which determines high price of commodities such as diamond, gold etc. which are least useful and low
price of a commodity such as water which is necessary and highly useful.
• Therefore, this came to be known as value paradox or water-diamond paradox. However, for modern economists there is no paradox about it as they are able to explain the large
price differential between water and diamond.
• The notion of marginal utility or marginal benefit of a commodity and the concepts of consumer surplus based on it can be used to resolve the water-diamond paradox. The
marginal benefit or marginal valuation per litre of water for the consumer is very low as the actual supply of water per period is very large.
• On the other hand, the marginal utility or marginal benefit of diamonds is very high because the amount of diamond actually available is very small. If, in fact, only a few litres of
water were available marginal valuation of water would have been much greater than that of diamonds.
• Note that marginal valuation of a commodity reflects how much amount of money consumer is prepared to pay for a commodity. This indicates marginal utility or use-value of the
commodity for the consumer. It is worth noting that downward-sloping demand curve for a commodity can be interpreted as showing the marginal valuation or marginal utility in
terms of money to the consumer of various units of a commodity.
• If the quantity actually available of a commodity in the market is very large, its marginal valuation or marginal utility will be very small, though its total use-value or total benefit
may be very large. On the other hand, as they actually available quantity of a commodity such as diamonds, gold etc. is very small, its marginal valuation or marginal utility is very
high, though its total value-in-use or total utility is small.
• Market price of a commodity is determined not by its total use-value but by its marginal valuation or marginal utility which in turn depends on the actually available quantity. The
total use-value or total utility which a consumer gets from a quantity of a commodity equals the amount actually paid and the consumer surplus he obtains from it.
• In case of water market price as determined by its marginal utility is very low but consumer surplus from it is very large. On the other hand, in case of diamond due to their
greater scarcity, marginal utility and hence its price is very high but consumer surplus from it is very small. Thus, the concept of consumer’s surplus shows that price should not be
confused with total use-value of a commodity and this helps us to resolve the water-diamond paradox.
• This is illustrated in Fig. 14.5 where consumer’s demand curve Dd depicts the marginal valuation curve for diamonds. On the X-axis quantity of diamonds in grams per time period
and along the F- axis marginal utility or valuation and price of diamonds are measured. Since the total use-value (i.e., total utility) of diamonds is small, the demand curve is at a
low level.
• Suppose the quantity of diamonds actually available is OQd and, as will be seen from the figure, price of diamond determined by demand and supply is Pd which is quite high,
whereas the consumer surplus equal to LAPd (shaded area) obtained by the consumers over and above what they actually pay is small.

14. Figure 14.5 also illustrates the price determination of
water. Demand curve Dw representing marginal valuation
or marginal utility of different quantities of water is at a
higher level. If the quantity of water available is a very
large quantity OQw, its marginal utility equals QwB and
therefore price determined is OPw.
Though the market price of water is very low, consumer
surplus obtained by the consumers will be the whole
shaded area (not fully shown) above the price line PwB
which is very large compared with those of diamonds.
To sum up, the total utility or satisfaction derived from
water consumed is much greater compared with
diamonds but its marginal utility is low due to its
abundant supply. The difference is large consumer
surplus. On the other hand, whereas total utility (value in
use) of diamonds is very small, due to its scarcity its
marginal utility and therefore its price are relatively very
high as compared with water. The difference is very small
consumer surplus.