Consumer Surplus (Importance, Criticisms and Assumption)

–

 

 

Consumer Surplus

French engineer and economist Arsene Jules Dupit (1804 – 1866) introduced the law of consumer’s surplus in 1844.

He used this concept to measure the social benefit.

Later, Alfred Marshall rediscovered and refined the theory of consumer surplus in his book Principles of Economics, published in 1890.

A consumer gets surplus when the price he/she actually pays is lower than the price he expects or is willing to pay.

 

The consumer surplus is a difference between the price willing to pay and the price actually paid in the market while buying the goods and services.

In other words, people generally get more satisfaction or utility from the consumption of goods than the actual price they pay for them.

That extra satisfaction obtained by the consumers from buying goods has been called consumer’s surplus.

 

According to A. Koutsoyannis, “Consumer’s surplus is equal to the difference between the amount of money that consumer actually pays to buy a certain quantity rather than go without it.”

 

Consumer surplus results when a consumer derives more benefit (in terms of monetary value) from a good or service than the price he/she pays to consume it.

 

Here, Amount = Rs = $ = £ = € = ₹ = Af = ৳ = Nu = Rf = රු = Currency of your country 

Imagine you are going to a Mobile Shop to buy a new midrange mobile phone set.

Before you go to the store, you decide to yourself that you are not going to pay more than Rs 16,000 (₹ 10,000 or $135) for a mobile phone set.

 

This Rs 16,000 is your maximum willingness to pay for the mobile set.

After entering the store, you find a mobile set you really like for only Rs 14,400 (₹ 9,000 or $122).

Since you were willing to pay Rs 16,000 for the mobile set; but, you only ended to pay Rs 14,400 for it.

You have saved Rs 1,600 i.e. 16,000 – 14,400.

 

This Rs 1,600 is called consumer surplus by economists, because it is the “extra” or “surplus” value you received from the good beyond the price you paid for it.

 

In short the consumer’s surplus (CS) is a difference between the price actually does pay and willing to pay.

 

Consumer’s surplus (CS) = WP – AP

Where,

WP = willing to pay price                        

AP = actually paid price

 

It is also expressed as:

Consumer’s surplus (CS) = TU – TS

Where,

TU = total utility or total benefit derived                 

TS = total amount spent

 

#####

Click on link for YouTube videos:
Accounting Equation	http://tiny.cc/c89jkz
Basic Journal Entries in Nepali	http://tiny.cc/uaakkz
Basic Journal Entries	http://tiny.cc/8aakkz
Journal Entry and Ledger	http://tiny.cc/caakkz
Ledger	http://tiny.cc/haakkz
Subsidiary Book	http://tiny.cc/399jkz
Cash Book	http://tiny.cc/889jkz
Trial Balance & Adjusted Trial Balance	http://tiny.cc/c59jkz
Bank Reconciliation Statement (BRS)	http://tiny.cc/q59jkz
Depreciation	http://tiny.cc/ugakkz
Final Account: Class 11	http://tiny.cc/y89jkz
Adjustment In Final Account	http://tiny.cc/keakkz
Capital and Revenue	http://tiny.cc/peakkz
Single Entry System	http://tiny.cc/n19jkz
Non-Profit Organization	http://tiny.cc/j09jkz
Government Accounting	http://tiny.cc/hcakkz
Goswara Voucher (Journal Voucher)	http://tiny.cc/hcakkz

#####

 

Assumption of the Law of Consumer Surplus

1. Expected price should be more than actual price

2. Marginal utility must be greater or equal to the price of commodity

3. Utility can be measured by utils

 

Here, Amount = Rs = $ = £ = € = ₹ = Af = ৳ = Nu = Rf = රු = Currency of your country 

The concept of consumer surplus for an individual consumer is represented in table.

Units of goods	Price ($/₹/Rs) willing to pay	Actual price ($/₹/Rs)	Consumer surplus
1	120	60	60
2	100	60	40
3	80	60	20
4	70	60	10
5	60	60	0
Total	430	300	130

 

In the table, a consumer is ready to pay Rs 120 for the first unit of the goods.

One actually does pay only Rs 60.

Now she/he has surplus Rs 60.

In the same way, the consumer is ready to pay Rs 100, Rs 80, Rs 70 and Rs 60 for second, third, fourth and fifth unit respectively.

But actually he pays only Rs 60, Rs 40, Rs 20, Rs 10 and Re 0 respectively.

 

Therefore, the consumer surplus

= 430 – 300

= 130

 

Instead of figuring out an individual’s surplus, let us figure out the total amount of surplus for all consumers in the market and derive the total consumer surplus.

An easy way to understand, it is shown in figure:

 

 

Suppose in this mini market we have 5 consumers and we line them up left to right by their willingness to pay (consumer 1 is willing to pay more than consumer 2 etc).

You can see that each consumer pays the same price (the market price is $5) for the good, so their surplus is calculated as the difference between their willingness to pay and the actual amount they have to pay.

 

For the first consumer, he is willing to pay $20, but only has to pay $5, so he gets a surplus of $15 (20 – 5).

The next consumer is willing to pay $16, but only has to pay $5, so he gets a surplus of $1 (16 – 5).

Using the same logic, the third, fourth and fifth consumers have surplus values equal to $5, $3 and $0 (because the maximum willingness to pay off the fifth consumer is equal to the price, so consumer surplus is zero.)

 

To get total surplus we add these values up, so $15 + $11 + $5 + $3 = $34.

The total consumer surplus in this market is $34.

But in reality, most graphs will not look like this.

So, let us do another example.

For this, let us consider following figure:

 

 

In the above figure, we have denoted price and marginal utility (in terms of price) on the Y-axis and quantity of goods on the X-axis.

In figure, you will see a typical linear demand curve denoted P_WD with a price line intersecting it at point E (which gives us equilibrium price and quantity).

Because point E is at equilibrium, Q_A is the quantity of goods that will be purchased from the market and consumers will pay a price of P_A.

 

We will use the information to calculate consumer surplus for this graph.

Remember that consumer surplus is equal to the difference between a consumer’s maximum willingness to pay (P_W) and the price that they do have to pay (P_A) actually.

 

Since the demand curve is above the price at points to the left of Q_A, each of these purchases results in surplus.

When P_A intersects the demand curve, there is no surplus and to the right of Q_A consumers are not willing to pay the price.

So, in the graphical example, we would have to calculate the area of a triangle which is equal to ½(base × height).

 

In our example, the base is equal to OQ_A (P_AE) and the height is equal to P_AP_W (maximum willingness to pay price OP_W minus actual price paid P_A).

This gives us consumer’s surplus equal to ½[(P_W – P_A) × Q_A]

 

Whenever you are asked to calculate consumer surplus, remember to insert/put the numbers given to you in this formula.

You should be able to figure out what the P_W is (where demand intersects the Y axis) and P_A and Q_A.

With this information, you just have to calculate the area of the triangle and you know what consumer surplus will be.

 

In terms of figure, consumers are willing to make payment equal to the area OP_W EQ_A to purchase the amount of goods equal to OQ_A.

The maximum willingness to pay price (P_W) is OP_W but actually the market price is only OP_A.

As the willingness to pay price is higher than the price that the consumer have to pay, there is consumer surplus.

 

Consumer surplus is equal to the shaded area of triangle P_WEP_A.

Thus, in graphical term area underneath the demand curve but above the price line is equal to consumer surplus.

 

Criticisms of Consumer Surplus

This law of consumer surplus is criticized by the several economists including Nicholas Kaldor, J.R. Hicks and P.A. Samuelson on the several grounds:

Marginal utility of money is not constant

This law assume that the marginal utility of money be constant out in practical life when the quantity of money be increase marginal utility of money be decreases.

Similarly, when the quantity money decreases, the marginal utility of money increases.

In the same way, when the income is increased, it decreases the marginal utility of money.

 

Imaginary theory

This law is only the imaginary law; because in real life nobody will be ready to pay more prices to the commodity than the actual price.

 

Utility is not measurable

The law of consumer surplus is based on the assumption that utility can be measured quantitatively in the term of money.

But, utility is subjective phenomenon, it cannot be measure quantitatively.

 

Not applicable to necessary goods

Consumer surplus is not applicable to the necessaries and luxurious goods.

A consumer is simply willing to acquire goods.

The consumer does not show any interest to get surplus.

 

Neglecting the complementary and substitutable goods

Consumer’s surplus neglects the complementary and substitutable goods.

The utility of any commodity is depends on others commodity.

But, this theory does not explain the role of complementary goods and substitution goods.

 

#####

Click on link for YouTube videos
Share (Accounting for Share)	http://tiny.cc/889jkz
Share in Nepali	http://tiny.cc/k99jkz
Debentures	http://tiny.cc/yeakkz
Final Account: Class 12	http://tiny.cc/e89jkz
Final Account in Nepali	http://tiny.cc/w89jkz
Work Sheet	http://tiny.cc/579jkz
Ratio Analysis (Accounting Ratio)	http://tiny.cc/4fakkz
Fund Flow Statement	http://tiny.cc/wiakkz
Cash Flow Statement	http://tiny.cc/8gakkz
Theory Accounting Xii	http://tiny.cc/nfakkz
Theory: Cost Accounting	http://tiny.cc/tfakkz
Cost Accounting	http://tiny.cc/p29jkz
LIFO−FIFO	http://tiny.cc/dgakkz
Cost Sheet, Unit Costing	http://tiny.cc/w49jkz
Cost Reconciliation Statement	http://tiny.cc/829jkz

#####

 

Importance of Consumer Surplus

Consumer surplus has the following significance or importance in economic analysis:

Determining price of goods and service

This law is very useful to determine the price of goods and services.

If the surplus is very high, the producer can determine high price of goods and services and vice versa.

 

Determining the tax rate

The law of consumer surplus is useful to government to determine tax rate.

The government can determine high rate of tax which goods and services have more consumer surplus and vice versa.

 

Guidelines for consumer’s and producer

This law of consumer’ surplus can be guidelines for both consumer and producer.

It can help to the consumer to maximize the surplus similarly it helps to the producer to maximize the profit.

 

Cost-benefit analysis

The law of consumer surplus helps in cost benefit analysis as well as in project selection.

If the expected cost incurred in production the project may be selected on the other hand the consumer fell that they are not getting any surplus, the project may not be selected.

 

International trade

The law of consumer surplus is significant to estimate the gain from the international trade.

The Government can produce that types of goods and service which have more consumer’s surplus.

 

Distinction between value in use and value in exchange

The law of consumer surplus helps us to distinguish between value in use and value of exchange.

Value in use means utility and value in exchange means price of commodity.

Commodities like salt, match box, medicine etc has a great value in use but very small value in exchange.

Consumer surplus from such commodities is very large because we are ready to pay much more for such commodities than we actual pay.

 

***** #EPOnlineStudy *****

Thank you for investing your time.

Please comment on article for improvement.

You can help us by sharing this article at your social media platform.

 

Jay Google, Jay YouTube, Jay Social Media

जय गूगल, जय युट्युब, जय सोशल मिडिया