OperationalSignificanceOfConsumersSurplus

Unit9

UNIT9

OPERATIONALSIGNIFICANCEOFCONSUMERS SURPLUS

Structure
9.1 Introduction Objectives 9.2 Meaningofconsumerssurplus 9.3 Operationalsignificanceofconsumerssurplus 9.4 Producerssurplus 9.5 Applicationoftwoconcepts 9.6 Summary SelfAssessmentQuestions TerminalQuestions AnswertoSAQsandTQs

9.1Introduction
TheconceptofConsumersSurpluswasfirstinventedbyaFrenchEngineerEconomistDupuitinthe year1844.Further,itwasrefinedandpopularizedbyProf.Marshallin1980.Hence,itiscalledas Marshallianconcept.Prof.BouldingdescribeditasBuyersSurplus.Itisoneofthemostcommon experiences in our day today life that many a times we come across surplus satisfaction in the process of consumption. Similarly, a producer sometimes earns surplus revenue than what he expects in the sale of a product. This surplus income enjoyed by the producer is described as producerssurplusineconomics. LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing 1. Understandtheconceptofconsumerssurplus. 2. Describetheimportanceandapplicationofconsumerssurplus. 3. Understandtheconceptofproducerssurplus 4. Makeadifferencebetweenconsumerssurplusandproducerssurplus.

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9.2.MeaningOfConsumersSurplus
Inamonetaryeconomy,wemeasuretheutilityofacommoditywiththehelpofprice.Thepricewe payforacommoditybasicallydependsonitsworthinessandutility.Ifaproductpossesseshigher utility,thenitwouldcommandahigherpriceandviceversa.ThelawofEquimarginalutilitystates that the pricepaidfor a commodity shouldbe equal to its marginal utility. This is oneof the basic conditionsfor consumers equilibrium.At the point ofequilibrium, neither there will behigher utility norlowerutility,butM.U=Price. In the real life, a consumer may not act according to the Law of equimarginalutility always. The balancebetweenthepriceandutilitymaynotbemaintainedalways.Sometimeshemaygetlower utilityfromacommoditywhencomparedtothepriceheispayingforit[[M.U<Price].Insomeother cases,hemaygethigherutility[M.U>price]. When the satisfaction obtainedby the consumer is much more than the price he is payingfor the commodity, he will be enjoying a surplus. The excess or surplus satisfaction enjoyed by a consumeroverandabovethepriceheispayingfortheproductratherthangowithout it is technically described as consumers surplus in economics. It is essentially found in the purchaseofusefulandverycheaparticleslikesalt,postcard,newspaper,matchboxandmanyother suchdurableandnondurablearticlesetc.Inallthesecases,wereceivemorethanwepayforthem. ConsumersSurplusmaybedefinedastheexcessofwhataconsumeriswillingtopayoverwhathe actuallydoespay.AccordingtoProf.Marshall,Theexcessofpricewhichapersonwouldbewilling to pay rather than go without the thing over which what he actually does pay is the economic measureofthissurplussatisfaction.Itmaybecalledconsumersurplus.InthewordsofProf.Bilas, The difference between what the consumer does pay for the commodity and what he would be willingtopayratherthandowithoutitiscalledconsignmentsurplus. Theconceptmaybeexplainedwiththehelpofaformula Consumerssurplus=whatwearepreparedtopay[minus]whatweactuallypay. It is the difference between exante and expost satisfaction. Also it is the difference between the potentialpriceandactualprice.Hence,itisthedifferencebetweenthevalueofthetotalutility thatmaybederivedfromtheconsumptionofaproductandthetotalamountofmoneyspent onthatproduct.

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Itisessentialtonotethatthereisaninverserelationshipbetweenpriceandconsumerssurplus.If pricerises,consumerssurplusfallsandviceversa. It is a productofopportunitiesand environment. For example, indeveloped countries consumers surplus is high because with a little amount of money the consumer can buy larger quantities of goodsand services. Onthe contrary, indeveloping countries, consumers surplus is lowbecause withmoreamountofmoney,theconsumercanpurchaselittleamountofgoodsandservices. TheconceptofconsumerssurplusisderivedfromtheLawofDiminishingMarginalUtility(L.D.M.U.). Itisclearfromthefollowingtable

Unitsof purchased 1 2 3 4 5 Totalunits

M.U.ofa inunits 50 45 40 35 30 Totalutility 200

Priceper unitinpaisa

Consumers surplusinunits

commodities commodity

30 30 30 30 30 Totalprice units=150

20 15 10 10 Nil Consumers surplus=50units 200150=50.

purchased=5 form5units= paidfor5

ConsumerSurplus=TotalUtility(PricexQuantity) SymbolicallyC.S.=TU(PxQ) =200(30x5) =200150 =50. C.S.=Whatwearepreparedtopay Whatweactuallypay. C.S.= 200150=50 (Inourexamplewemeasurethat1unitofutilityisequalto1paisa).

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Consumers` Surplus P

R Price Areaof Expenditure MU/D X

Quantity

Inthediagram, OD=Pricewillingtopay OQ=Quantitywillingtobuy ODXOQ=ODPQ=Totalexpenditurewillingtoincur OR=ActualMarketprice OQ=Actualquantitypurchased ORxOQ=OPPQ=Actualexpenditureincurredbytheconsumer. Therefore,C.S.=Pricewillingtopaypriceactuallypaid=ODPQORPQ=RDP. Itistoberememberedthattheconceptisbasedonanumberofunrealisticassumptions.Itposesa number of difficulties in its measurement. Hence, always it is not possible to measure the exact volume of consumers surplus. In spite of several practical problems, economists have made successfulattemptstomeasureitaspreciselyaspossible.

9.3OperationalSignificanceOfConsumersSurplus
1.ConjecturalAdvantages Theconceptenablesustocomparetheadvantagesofenvironmentandopportunitiesorconjectural benefits.Theconjecturalbenefitsderivedbypeopleenableustocomparethestandardsoflivingin differentpartsoftheworld.Ifconsumerssurplusismoreinanycountry,thenlivingstandardsofthe peoplearehighandviceversa.Forexample,thelivingstandardsofthepeopleofUSAorJapanis

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certainly more when compared to India because in those countries the national output, national income and per capita income of the people are high Thus, it helps to measure the volume of economicwelfareofthepeoplewholiveindifferentpartsoftheworld. 2.Useincostbenefitanalysis Todaytheconceptisextensivelyusedinestimatingthecostbenefitsofvariousinvestmentprojects both in the private and public sectors. Costs and benefits do not merely mean money costs and monetary benefits but also real costs and real benefits in terms of satisfaction and the amount of resourceutilization.Thequantumofconsumerssurplusderivedfromsocialprojectslikerailways, roads, bridges, dams, flyovers, parks, libraries, water and electricity supply etc by consumers are definitelyhigherwhencomparedtotheamountofmoneyspentonthem.Forexample,aconsumer wouldpayaverylittleamountofmoneytotravelinapublictransportvehiclethanwhathehastopay if he were to travel in an autorikshaw or taxi. The cost savings from these projects are directly derivedfromconsumerssurplus. 3.UseinpublicFinance a.Itisthebasistoimposetaxesonpeople.Ifconsumerssurplusishighincaseofanyproductor service,thenthefinanceministercanimposehighertaxesonthemandviceversa.Thisisbecause peoplearereadytopaymorepriceforsuchproductsratherthangowithoutthem. b.Itisthebasistodeclarewhethertaxationpolicyofagovernmentisgoodorbad.Ifthegaintothe governmentonaccountoftaxcollectionisgreaterthanthelossestotheconsumersonaccountof taxpayment,itisagoodtaxationpolicyandviceversa.Inthiscase,thetotaltaxamountcollected bythegovernmentisgreaterthanthatofthetotalamountofsacrificemadebythepeopleonaccount oftaxpayments. c.Itisthebasistograntsubsidybythegovernmenttoprivateentrepreneurs.Iftheamountofgainto the people on account of subsidy isgreater than thefinancial lossto thegovernment owingto the grant of subsidy, we can justify such subsidyand vice versa. Forexample, if governmentgrants subsidytosugar,marketpriceofsugardeclinesandconsequently,moreconsumerswouldbuymore quantityofsugarandenjoygreateramountofsatisfaction. 4.Pricingofpublicutilities. Theconcepthelpsindeterminingpricesofpublicutilities.Incaseofconstructionofrailwaylines,air ports,roads,bridges,generationandsupplyofelectricity,watersupplyetc,peopleenjoyenormous

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amount of surplus satisfaction. While fixing the prices of these services, or commodities, the government does not look into its production and supply cost. As they are public utilities, the governmentfollowsthepolicyofpricediscrimination. 5.Helpstoresolvetheparadoxofvalue Generallyspeakingmarketvalueofproductdependsonitsdemandandsupply.Incaseofcertain essentialcommoditieslikewateretcsupplywillbemoreandassuchitsmarketpricewillbelow.In thesecases,marginalutilitywillbelowwhatevermaybethevalueoftotalutility.Incasethereis scarcity of aproduct in the market, its price would go up. In this case, marginal utility will be high whatever may be value of total utility. Commodities which have more value in use give more satisfaction than others which have more value in exchange. For example, in case of salt, match box,newspaper etc total utility is morebut marginalutility is less and as such we pay much less moneyforthem.Valueinuseincaseofsuchgoodsismuchhigherthantheirvalueinexchange. Commodities which have more value in exchange give less satisfaction than others which have morevalueinuse.Forexample,incaseofdiamond,valueinexchangeismorethanvalueinuse because in these cases, marginal utility is higher than total utility. Thus, the concept helps to distinguishbetweenvalueinuseandvalueinexchange. 6.UsemonopolyPricing Ithelpsthemonopolisttopracticepricediscrimination.Ifconsumerssurplusishigh,incaseofany commodityorservice,thenthemonopolistcanchargehigherpricesandviceversa. 7.UseininternationalTrade Itisthebasistoimportcertainitemsfromothercountries.Ifconsumerssurplusismoreincaseof importedgoodsthandomesticallymanufacturedgoods,inthatcaseitisbettertoimport.Similarly,if consumers surplus is low with in the country and high in othernations, in that case, it is better to exportthemtoothernations. 8.UseinwelfareEconomics Itisusedasatoolinwelfareeconomics.Thedoctrineemphasistheadvantagesderivedduetoafall inthepricesofthecommodities.Fallinpriceleadstoriseintherealincomeoftheconsumerand this will definitely raise the level of welfare of the people, the level of economic well being of the people is higher in those countries. According to Dr. Little, the government should adopt those economic policies whichpromote consumers surplus. Such policies will certainlyhelpto increase theeconomicwelfareofthepeopletothemaximumextent.

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9.Useinintroductionofnewproducts Ifconsumerssurplusisgreaterinthecaseofintroductionofanewproductthanthedisappearance of theoldproduct, we can justifythe introduction ofa new product into the market. Thishelps the consumerstomaximizetheirsatisfaction. Thus the concept of consumers surplus has great practical application in all most all fields of economicactivities.

9.4ProducersSurplus
Itisparallelconcepttoconsumerssurplus.Producerssurplusisownerssurplus.Itmaybedefined astheexcessorsurplusincomereceivedbyaselleroverabovethepriceatwhichheis willingtosellaproduct.Itisthedifferentbetweentheactualpriceatwhichheissellingandthe priceatwhichheiswillingtosellHence,itariseswhentheactualpricereceivedexceedsthe minimumpricethatthesellerisreadytoaccept. Producerssurplus=whatthesellerisactuallyreceivingwhatthesellerisreadytoreceive. Itisthedifferencebetweenexpostandexanteincomereceived. IllustrationInRs. Unitsof sold 1 2 3 4 5 Totalunits sold=5 Priceat actuallysold 25 20 15 10 05 Totalprice receivedfrom Priceat whichready tosell 5 5 5 5 5 Totalprice 20 15 10 05 Nil Producerssurplus =5000. Producers surplusinRs.

commodities which

expectedfrom =75002500 00

5units=7500 5units=25

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Producers=Totalreceipts(PricexQuantity) SymbolicallyP.S.=TR(PxQ) =7500(5x5) =75002500 =5000 P.S.=Whatsellerreceives Whatsellerexpects. P.S.= 75002500=5000 (InourexampleweassumecostpriceisRs.500andminimummarketpriceisRs.500]
Y

S N Surplus

M Price S

Areaof Actual Receipt Q Quality X

Inthediagram, OM=ActualPricereceived. OQ=Actualsales OMXOQ=OMNQ=Totalpricereceived. OS=Priceatwhichwillingtosell OQ=Supplywillingtomake OSxOQ=OSNQ=Priceexpectedtoget. Therefore,P.S.=Pricereceivedpricewillingtoreceive=OMNQOSNQ=SNM. Producerssurplusmayappearasprofit.Ingeneralitistrue.Itmayalsotakesomeotherforms.For example,marketpriceofwheatmayincreasefromRs.3000to4000.Consequently,moreland may be brought under wheat cultivation. Now farmers, who are cultivating and selling wheat, are enjoyingproducerssurplusofRs.1000.onaccountofincreaseinwheatpriceinthemarket.

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Similarly,riseinwheatpricemayincreasethedemandforlandforwheatcultivation.Thisleadsto increase in the land price. Hence, landlords as resource owners would earn more rents on land. Thus,producerssurplustakestheformofincreasedrentsonland.Recentincreaseinthepriceof cricketersisanotherexample. Emergenceofconsumerssurplusandproducerssurplus Asimpleexamplemaybegiventoshowtheemergenceofboththesesurpluses VivekisasellerandisreadytosellhisCDatRs.2000 ViveknowsellstheCDatRs.3000. Producerssurplus=pricereceivedpricereadytocharge.30002000=1000 VinayisreadytopayRs.4000forthesameCD VinaynowbuytheCDatRs.3000 Consumerssurplus=Pricereadytopaypriceactuallypaid.=40003000=1000. Theconceptsofbothconsumerssurplusandproducerssurpluscanbeexplainedwiththehelpof demandandsupplycurvessimultaneously.

Y S D

E R Price A D

S 0
S

B X Quantity

Intheabovediagram,priceisrepresentedonYAxisandquantitydemandedandsuppliedonXAxis. DemandandsupplyareequalatE.ORistheequilibriumpriceandOQistheequilibriumquantity demanded and supplied. In the diagram. The consumer is ready to pay OD price and he actually paysORprice.Hence,consumerssurplusisRDEie,areaA.Generallyconsumerssurplusisthe area under demand curve and above the market price line. Hence, the area A is the consumers surplusinthediagram. ThesellerisreadytoaccepttheminimumpriceofOSandsellsitatORprice.Hence,producers surplusisSRE,ie,theareaB.Producerssurplusistheareaabovethesupplycurveandbelowthe
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marketpricelineHence,theareaBisproducerssurplus. Thus,withthehelpofonediagramwecan explaintheemergenceofbothsurpluses.

9.5ApplicationOfTwoConcepts
In any market, if sellers collude with each other,they can raise thepriceand transfer someofthe consumerssurplusintoproducerssurplus.Inthesamewayconsumerscanorganizethemselves in to strong groups under certain situations and decrease the price and take away some part of producerssurplus. Now sellers can organize against consumers and restrict output and increase the market price. Generallythiscanhappenwhenthefirmsenjoysomeamountofmonopolypowerinthemarket.If price rises, quantity demanded falls in accordance with law of demand. Consequently output is restricted.Thevolumeofconsumerssurplusshrinks.Thisleadstotransferofconsumerssurplusto producers surplus. As a result of rise in price, producers surplus increases. It is to be noted that after rise in price, if the volume of producers surplus is greater than consumers surplus, then producersgain. In a similar manner, buyers can organize together against sellers and capture producers surplus. This is possible where there are a few buyers and many sellers in the market, where buyers can restricttheirpurchasesanddecreaseprice.

9.6Summary
Consumers surplus is the difference between what a consumer is prepared to pay minus what a consumer actually pays. The volume of consumers surplus varies with variations in price. When price rises, consumers surplus falls and viceversa. In several cases, we come across a situation whereinaconsumerwouldenjoysurplussatisfactionthanwhatheexpects.Economistshavemade successful attempts to measure the volume of consumers surplus in spite of several practical problems.Thetotalamountofconsumerssurplusistheareabelowthedemandcurveandabove the price line. The concept helps in making various types of costbenefit analysis of public investmentswhichdeterminestheamountofpublicwelfare.Theconceptisusefullyemployedinall mostallbranchesofeconomicactivities. Producerssurplusisaparallelconcepttoconsumerssurplus.Itisthedifferencebetweentheprice received and the price he is willing to charge. The total amount of producers surplus is the area

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above the supply curve and below the price line. The volume of producers surplus directly varies withvariationsinprice.Highertheprice,higherwouldbethevolumeofproducerssurplusandvice versa.Dependingonmarketsituations,producerstrytoconvertconsumerssurplusintoproducers surplusandconsumerswouldtrytoconvertproducerssurplusintoconsumerssurplus. SelfAssessmentQuestions1 1. Theconceptofconsumersurplusisbasedondemandtheoryby____. 2. Ifthepriceincreasestherewillbe____inconsumersurplus. 3. _____isusedtojudgethedesirabilityofpublicinvestmentofanypublicprojectsorinvestment 4. Theexcessburdenornetlossinwelfareiscalled______. 5. The direct or indirect payment by government to producers or consumers to defray part of the costofeconomicactivityiscalled____. 6. ____existswhentheactualpriceexceedstheminimumpricethatthesellerisreadytoaccept. TerminalQuestions 1. ExplaintheconceptofConsumerssurpluswithsuitableillustration. 2. DiscusspracticalimportanceofConsumerssurplus. 3. ExamineconceptofProducerssurpluswithexamples. 4. Explaintheemergenceof Consumerssurpluswiththeirpracticalapplication. AnswertoSelfAssessmentQuestions SelfAssessmentQuestions1 1. Marshall 2. Decrease 3. CostBenefitAnalysis 4. Deadweightloss. 5. Subsidies 6. Producerssurplus

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AnswertoTerminalQuestions 1. Referunit9.9.2 2. Referunit9.9.3 3. Referunit9.9.4 4. Referunit9.9.4

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