MCom I Semester Managerial Economics Consumer Surplus Study Material Notes

MCom I Semester Managerial Economics Consumer Surplus Study Material Notes: Meaning and Definition of Consumer Surplus Explanation of Consume Surplus or Measurement of Consumer Surplus Assumptions of Consumers Surplus Difficulties in the Measurement of Consumer Surplus Importance of the concept of consumer Surplus Hickslan Approach of Consumer Surplus :

MCom I Semester Statistical Analysis Simulation Study Material Notes

CONSUMER’S SURPLUS

The concept of consumer’s surplus was introduced by Prof. Duputt of France, but this concept was popularized by Prof. Marshall. Therefore, Marshall is known as the introducer of this concept.

MEANING AND DEFINITION OF CONSUMER’S SURPLUS

According to the law of diminishing marginal utility, utility of every additional unit of a commodity goes on diminishing. For this reason, the consumer agrees to buy additional units of a commodity only when they are offered to him at a lower price. Thus, he can purchase initial units at a higher price, but additional units only at a lower price. In actual life, the price paid by a consumer for all the units is equal. He purchases a commodity till its marginal utility is equal to the price paid for it. Thus, he does not get any surplus on the consumption of marginal unit. But on all the units consumed earlier, he gets a surplus. This surplus is known as consumer’s surplus. This concept has been defined as under:

1 “The excess of the price which he would be willing to pay rather than go without the thing, over that which he actually does pay is the economic measure of this surplus satisfaction. It may be called consumer’s surplus.” – Marshall

2. “Consumer’s surplus obtained by a person from a commodity is the difference between the satisfaction which he derives from it and which he foregoes in order to produce that commodiny.” -J.K. Metha

3. “The difference between what we could pay and what we have to pay, is called consumer’s surplus.” –Penson Thus, consumer’s surplus is the difference between the price paid for a commodity and the utility derived from its consumption.

EXPLANATION OF CONSUMER’S SURPLUS OR, MEASUREMENT OF CONSUMER’S SURPLUS

There are two approaches of the measurement of consumer’s surplus

(1) Marshall’s Approach (Difference between total utility and marginal utility). Due to the application of law of diminishing margina utility, marginal utility of every additional unit of consumption goes on declining. Therefore, he is ready to pay more price for the first unit and less price for subsequent units. He purchases the commodity till its marginal utility and price are equal. The last unit is called marginal unit. Thus, he gets surplus utility on all the units prior to such marginal unit and this is his surplus.

Thus,

Consumer’s surplus = Total utility-Marginal utility Example. A consumer wants to consume bananas. Price of banana is 50 paise per banana. As a consumer increase the consumption of banana, utility derived by him will go on diminishing. He will continue till marginal utility of banana is equal to the price paid for it. It can be presented as follows:

(2) For Divisible Goods. For divisible goods like, milk, ghee, flour etc., consumer’s surplus can be presented with the help of following diagram :

ASSUMPTIONS OF CONSUMER’S SURPLUS

(1) Application of the Law of Diminishing Marginal Utility. Concept of consumer’s surplus is based on the law of diminishing marginal utility. In the absence of this law, the consumer cannot get any surplus.

(2) Measurement of Utility. It assumes that utility is an objective concept. It can be measured in terms of money.

(3) Constant Marginal Utility of Money. It assumes that there is no change in the maginal utility of money during the course of consumption.

(4) Constant Income of Consumer. It assumes that there is no change in the income of consumer during the course of consumption.

(5) Constant Tastes, Preferences, Fashion etc.. Utility of a commodity are considerably affected by tastes, preferences, habits fashion etc. Therefore, for the concept of consumer’s surplus, there should be no change in these factors.

(6).No Close Substitute. Concept of consumer’s surplus assumes that there is no close substitute of the commodity available in market. If it is there, the consumer does not know about it.

DIFFICULTIES IN THE MEASUREMENT OF

CONSUMER’S SURPLUS OR, CRITICISMS OF THE CONCEPT OF

CONSUMER’S SURPLUS

(1) Utility Cannot be Measured. Consumer’s surplus is only a psychological concept because the utility cannot be measured in terms of money.

(2) Marginal Utility of Money Does not Remain Constant. This concept is based upon assumption that the marginal utility of money remains constant, but the fact is that it goes on increasing with every additional unit of purchase.

(3) Difference in the Level of Income of Consumer’s. Some consumers ale rich while others are poor. Consumers surplus of rich people is much higher than that of poor people.

(4) Tastes and Preferences of Consumer Differ. Tastes and preferences of consumers also differ. As a result, surplus received by them from the consumption of a particular commodity also differs.

(5) Difficulties due to Substitutes. Presence of substitute goods also creates difficulty in the measurement of consumer’s surplus. Example : Tea and coffee are substitutes to each other. Marginal utility of tea could have been more in the absence of coffee and vice-versa.

(6) Consumer’s Surplus for Necessities is Infinite. This concept does not seem to be real in case of necessities. Example: A thirsty man can agree to pay any amount for a glass of water but it cannot be regarded as consumer’s surplus.

(7) Consumer’s Surplus of Prestigeous Goods is Uncertain. Prestigeous goods are purchased by the consumers, who are very rich. Surplus received by them on the purchase of these goods cannot be measured.

HICKSIAN APPROACH OF CONSUMER’S SURPLUS OR, MODERN APPROACH OF CONSUMER’S SURPLUS

Concept of consumer’s surplus as propounded by Prof. Marshall is based on the assumption that utility is an objective concept and it can be measured in terms of money. Modern economists like Prof. Hicks, Prof. Allen, etc., do not agree with it. According to them, utility is a psychological concept which cannot be measured. A consumer cannot compare the utility of two commodities in absolute terms. He can compare only the satisfaction he gets. He can give an order of preference to various commodities. Therefore, these economists have explained the concept of consumer’s surplus with the help of indifference curves.

According to the approach of Hicks, a fall in the price of a commodity affects the position of a consumer in two ways

(i) The consumer can purchase more quantity of same commodity or he can use this surplus on a substitute commodity.

(ii) The consumer has to pay less for a given quantity of it. These two effects generate a surplus for consumer which can be regarded as consumer’s surplus. It can be explained with the help of following diagram :

In the diagram, quantity of commodity has been presented on OX axis and income of consumer has been presented on OY axis. AB is the price line. IC, is the original indifference curve and P is the original point of equilibrium. Consumer is buying OQ quantity of the commodity at this point and spends AM or LP money for the purpose. IC, is the second indifference curve, which represents that though the consumer is ready to spend AN or LS money to purchase OQ quantity of commodity but actually he spends AM or PL money for the purpose. Thus, he is getting a saving of AN-AM = MH money. This is his surplus.

IMPORTANCE OF THE CONCEPT OF CONSUMER SURPLUS

(1) Conjuncture Importance. The concept of consumer’s surplus enables us to compare the prosperity of people. If consumer’s surplus of people is high, they will be more prosperous and vice-versa.

(2) Importance in the Determination of Monopolistic Price. If the commodity produced by a producer is a monopoly item, he can fix higher price for it because the consumers will be ready to pay more for such commodity.

(3) Helpful in Comparing the Profit of International Trade. A country imports only those commodities which are scarce and costly in local market and exports only those commodities which are aboundant and comparatively cheaper.

(4) Importance in Public Finance. Marshall stated that a finance minister should consider consumer’s surplus while imposing taxes and while granting economic assistance to industries. A tax should be imposed only when an increase in the income of the government resulting from such tax is more than the decline in consumer’s surplus.

Thus, it may be concluded that the concept of consumer surplus is used in many spheres of life. Robertson stated, “Provided, you do not expect too much from it, the concept of consumer’s surplus is both intellectually respectable and useful as a guide to practical action.”

Consumer Surplus Study Material