Consumer surplus and Producer surplus

Consumer surplus and Producer surplus

The concept of consumer's surplus was originally stated by  Jules Dupuit in 1844. Later on,  it was properly  elaborated by Dr. Alfred Marshall in his book ‘Principles of Economics.'

Consumer surplus is the difference between what we are willing to pay and what we actually pay.

 According to Prof. Marshall “The excess of the price which he (consumer) 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”.

According to Penson – “The difference between what we would pay and what we have to pay is called Consumer’s Surplus.”

Example: Suppose a consumer is willing to pay Rs.10 for a pen but the cost of that pen is only Rs.5, so the consumer actually pays only Rs.5 for it.

Consumer's surplus= the price which the consumer is willing to pay- the price that he actually pays

CS= RS 10 - RS 5 = RS 5

Thus, Consumers' surplus is the net gain to the consumer from the purchase of a commodity or a service. It is equal to the difference between the consumer's willingness to pay and the price actually paid.

Consumer's Surplus and the Law of Diminishing Marginal Utility: 

The concept of Consumer's surplus is derived from the law of diminishing marginal utility. The consumer all the time will not be willing to pay more for the commodity. If the utility derived from the commodity is more, the consumer will ready to pay more for the good. As the consumer consumes more units of the commodity, he receives less and less utility from each successive unit than before. That's why for initial units, he is willing to pay more than later units. Since the price is fixed for all the units of the commodity he purchases, he gets extra utility from the initial units and this extra utility is called Consumer's surplus.

Consumer Surplus =  Total Utility - [Price x Quantity of the commodity]

Symbolically,

C S =  TU - [P x Q]

As TU = ∑ MU

Where ∑MU = the sum total of marginal utility

C.S = ∑MU –  (P × Q)

Units of Commodity	Marginal Utility (Imaginary price)	Market Price (in Rupee)	Consumer's Surplus
1	50	10	50-10=40
2	40	10	40-10=30
3	30	10	30-10=20
4	20	10	20-10=10
5	10	10	10-10=0

Assumptions of consumer surplus theory: According to Marshall’s theory, the main assumptions of consumer’s surplus are-

1. Utility can be measured in terms of money:  It is assumed that utility is a quantifiable entity and can be measured by assigning definite numbers such as 1, 2, 3, etc.

2. No alternative commodities are available: There should be no substitute available in the market for the application of this law.

3. No change in taste, income, and fashion: The customer’s income, tastes, preferences, and fashion remain unchanged during the analysis.

4. Marginal utility of money is constant.  It is assumed that the marginal utility of a commodity varies with the quantity of the commodity purchased, but the marginal utility of the money remains constant. This assumption becomes necessary because we measure the marginal utility of a commodity in terms of money.

5. Concept of diminishing marginal utility: As the consumer consumes more units of the commodity, he receives less and less utility from each successive unit than before. That's why for initial units, he is willing to pay more than later units. 

6. Utilities are independent: It is assumed that the utilities of different commodities are independent of one another. In other words, the utility derived from the consumption of one good is the function of that good alone and not of another.

Consumer’s Surplus and Form of Market: In the calculation of consumer's surplus, we assume a perfect market where the price is the same for all the units of the same commodity. We can measure consumer surplus for an entire market (a group of individual consumers) with the help of the market demand curve and market price line.

In this figure, DD represents the market demand curve which shows the price that the group of consumers is willing to pay for the successive units of a commodity. PB denotes the market price line. PB is horizontal, which implies that the market price is the same for all units of the commodity. Point E represents the equilibrium point where the market demand curve intersects the market price line. OQ represents the quantity of the commodity that the group of consumers purchases in the given price and equilibrium position. ODEQ represents the money the group of consumers is willing to pay for OQ units of the commodity.

However, OPEQ is the actual amount spent by the consumer to get OQ units of the commodity. DPE is a consumer surplus.

Limitation of the Law: The measurement of consumer’s surplus is not as simple as it seems. There are numerous difficulties which create hurdle in the measurement of consumer’s surplus.

1. It is very difficult to measure the utility gained from different units of a commodity consumed by a consumer. Hence, the measurement of consumer’s surplus is difficult.

2. In the case of necessary and prestigious goods, Consumer surplus is indefinite and immeasurable.

3. Taste, preference, habits, and the income of the consumer do not remain the same. Apart from it, tastes and preferences are different for various consumers for the same commodity.

4. The marginal utility of money does not remain constant. As the stock of money decreases, the marginal utility of money increases.

5. There is difficulty arising because of the presence of substitutes.

The concept of consumer surplus given by Marshall was criticized on several bases such as it is imaginary and difficult to measure. A man cannot always say what he will be willing to pay rather than go without the thing. The main point of criticism is that it is incapable of precise numerical measurement.

Measurement of consumer’s surplus with Indifference curve:

The concept of consumer’s surplus given by Marshall was criticized mainly because of the difficulty arising to measure it in cardinal numbers. According to Hicks and Allen, utility is a subjective phenomenon and it cannot be measured in terms of money.

Prof.J.R.Hicks has rehabilitated the concept of consumer’s surplus by approaching it in terms of ordinal utility function or indifference curve technique.

Suppose the price in the market as represented by the price line LM. With this price in the market, he will be in equilibrium at point H on a higher indifference curve IC2. And in this equilibrium position, he will actually give up FH (=LT) amount of money for OQ of commodity X. But ignorance of the price in the market he was prepared to pay FR[=LS] amount of money for OQ of the commodity X shown on IC1. Thus he is paying less money for the same quantity (OQ). HRTS is the consumer’s surplus for the consumer.

Importance / Application of Consumer's Surplus:

The concept of consumer’s surplus has great practical utility and serves as a tool of modern economic welfare analysis.

1. Distinction between Value-in-use and Value in Exchange: The satisfaction or utility which the consumer receives from the use of a commodity is known as the value-in-use.

Value in exchange means the number of goods and services which the consumer may obtain in the market in exchange for a particular thing or we can say for money.  

Necessary goods like basic food items have a great value-in-use but much less value in exchange. That's why the consumer obtains a large Consumer’s Surplus in necessary goods. The Consumer’s Surplus depends on total utility, whereas the price of the good or service depends on marginal utility.

2. Importance in Public Finance: It is useful to a Finance Minister in imposing taxes. He will impose a tax on those commodities in which the consumers enjoy more surplus.

3. Useful to Monopolist: This concept is very useful for the monopolist also. He can increase the prices of those commodities in which there is a large consumer surplus.

4. Comparison of Gains from International Trade: Consumer’s Surplus helps us to compare the relative gains from international trade. We can import those goods which are cheap or less in price in another country compared to native country The imports, therefore yield satisfaction or we can say Consumer’s Surplus. The larger the consumer's surplus, the more beneficial is international trade.

5. Comparing the advantages of different places: We compare the advantages of the environment and opportunities with the concept of consumer’s surplus. A person living in a developed area enjoys a greater consumer surplus than a person living in an undeveloped area. We can also compare the standard of living of the people living in different parts of the world. People getting the larger the consumer’s surplus are in better condition.

Thus, it is clear that the concept of consumer’s surplus is having great practical value.

Producer surplus

Producer surplus is the difference between the price at which the producer is willing and able to supply his product and the price that he actually receives. It is equal to the value that the seller actually receives minus the value that the seller is ready to receive.

For example, the producer is willing to sell his product at Rs 10 but he actually receives Rs 20, so the producer surplus is :

Producer surplus= actual price- minimum acceptable price

PS= 20-10=10

Thus, Producer surplus is the difference between the actual price producer receives and the minimum acceptable price.

In the diagram, the Producer surplus is shown by the area [PSE] above the supply curve and below the market price. 

Producer surplus can be defined as the excess or surplus income received by the seller on the price at which he was willing to sell his product.

Producer surplus and price are directly related. The higher price of the product, the more producer surplus.

Producer surplus is essential for the producers for the growth and expansion of the business.

Both  consumer and producer surplus:

Markets are efficient when consumers and producers both surplus are maximum.

In the diagram, consumer surplus is shown by the area [PDE] above the market price and below the demand curve and the producer surplus by the area [PSE] above the supply curve and below the market price.
Both surpluses are helpful while making price policies. When a producer increases the price of his product, producer surplus increases, but consumer surplus falls. Consumers who were having a small amount of surplus will no longer be willing to purchase products at higher prices, which can result in a decrease in total producer surplus. A rational producer will keep both aspects in his mind while setting the price of the product so that it can give the surplus to the producer and consumer.

Dr. Swati Gupta

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