BCom 1st Year Consumer’s Surplus Notes Study Material
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BCom 1st Year Consumer’s Surplus Notes Study Material
Introduction to Consumer’s Surplus
The term consumer’s surplus and its rigorous analysis was first introduced by Alfred Marshall, although the credit of first developing the idea goes to A.J.E.J. Dupuit who in 1844 did it in his analysis of the pricing of public services. Dupuit was trying to find out the extent of the subsidy to be granted towards the total cost of constructing a bridge. Following him, Marshall defined consumer’s surplus in the following words:
“It is the excess of the price he (the consumer) would be willing to pay rather than go without the thing over that which he actually does pay.”
(1) Marshall’s Concept of Consumer’s Surplus
Marshallian consumer’s surplus is the area under an individual’s Marshallian demand curve between two prices. It is a monetary measure, although it was originally represented by him in terms of surplus utility. As he points out, the price which a person pays for a thing can never exceed and seldom comes up to that which he would be willing to pay rather than go without it.
So the satisfaction which he gets from its purchase generally exceeds that satisfaction which he gives up in paying away its price. He “thus derives from the purchase a surplus of satisfaction”, i.e., utility. In this way Marshall expresses consumer’s surplus in terms of surplus utility.
Marshall then measures this surplus utility in terms of the excess of the price which the consumer would be willing to pay rather than go without the thing over that which he actually does pay. This excess price is the monetary measure of consumer’s surplus satisfaction or utility.
It is important to note here that in order to know the excess price, called consumer’s surplus, Marshall tries to find out that optimum which the consumer will be willing to pay in an all-or-none-situation. The consumer is offered the alternative of either purchasing the good in the quantity offered or none at all. Consumer’s surplus turns out to be that area under the Marshallian demand curve which lies above the rectangle representing the consumer’s actual monetary expenditure incurred to get the commodity.
This surplus arises because the slope of the demand curve is negative. From the negative slope it follows that a consumer pays less than he would be willing to pay for the total amount of any good that he consumes. Thus consumer’s surplus is the difference between what a consumer would be willing to pay-which is the value of the total utility that he derives from consuming the product-and what he actually does pay-which is his total expenditure on that product.
Consumer’s surplus is graphically presented in fig.
In the figure DD’ is the demand curve of a consumer. At the price OP, the consumer purchases OM of the commodity. In order to obtain OM, he is willing to pay a sum equal to ODAM. The price which he actually pays is the rectangle OPAM. Thus the area DPA under the demand curve—the shaded triangle in the diagram-is the consumer’s surplus. This triangle will be a curvilinear triangle in the case of a nonlinear demand curve.
The paradox of value emphasizes that the recorded money value of a good (which is price x quantity) may be a misleading indicator of the total economic value of that good. Adam Smith’s examples of water and diamond are well known. The gap between the total utility of a good and its total market value is called consumer’s surplus.
In fig, the total utility of the good is ODAM, while total market value is OPAM. The gap between them is DPA which is consumer’s surplus. This surplus arises because of the law of diminishing marginal utility (the negative slope of the demand curve). We pay the same price for each unit of a commodity that we buy, from the first to the last, but the price that we pay for all the units purchased is equal to the utility of the last or marginal unit (price = marginal utility). So a surplus of utility is enjoyed on each of the earlier units.
From the above the following conclusions can be drawn:
(i) Consumer’s surplus is the excess of price. There is a price which the consumer is willing to pay. Another price is that which he actually pays which is lower than the first. The difference between the two prices is the excess of price—DAP in fig. Here consumer’s surplus is expressed in monetary terms.
(ii) Consumer’s surplus can be expressed in terms of excess of utility. In this sense the demand curve DD’ becomes the utility curve. The rectangle showing the actual amount paid is the effective utility. In fig, OPAM is the effective utility (i.e., units of the good purchased x marginal utility). DAP is the consumer’s surplus.
Marshall points out that consumer’s surplus derived from some commodīties is much greater than that from others. This surplus derived from purchasing at a low price things for which the consumer would rather pay a ugh price than go without them, may be called the benefit which he derives on his opportunities or environment or conjuncture. Thus consumer’s surplus is a conjunctural gain and it is based on the law of diminishing marginal utility.
In the table the case of tea purchased for domestic consumption has been shown. If the price of tea were Rs. 20 per 100g he would just be induced to purchase 100g weekly (price = marginal utility). If the price were Rs. 18 per 100g he would be induced to buy 200g; 300g if the price were Rs. 15; 400g if the price were Rs. 13 per 100g; 500g if the price were Rs. 12 and 600g if the price were Rs. 10. Since the actual price is Rs. 10 per 100g, so he does buy 600g. Let us now investigate the consumer’s surplus which he derives from purchasing 600g of tea at a price of Rs. 10 per 100g.
Since the consumer is just induced to buy 100g if the price were Rs. 20, it suggests that the total utility (enjoyment or satisfaction) which he derives from that 100g is as great as that which he could obtain by spending Rs. 20 on other things. At a lower price of Rs. 18, he could, if he so liked, continue to buy only 100g and obtain a surplus satisfaction of at least Rs. 2.
So the consumer’s surplus is Rs. 2. But he buys 200g in fact of his own accord. It means that the second 100g is worth at least Rs. 18, equal to the marginal utility of the second 100g. Thus he obtains Rs. 38 worth of satisfaction from 200g of tea for which he pays only Rs. 36. If he buys the second unit of tea, his surplus satisfaction is not diminished by buying it; it remains at least Rs. 2. Total utility of 200g of tea is at least Rs. 38, his consumer’s surplus is at least Rs. 2
When he purchases 600g of tea, his total utility is worth Rs. 88, but he pays only Rs. 60 (he purchases 600g only when the price falls to Rs. 10 per 100g which is equal to the marginal utility of the sixth unit). Thus consumer’s surplus is Rs. 28, the excess of the sum of Rs. 88 over Rs. 60.
Marshall says that the consumer derives this Rs. 28 worth of surplus satisfaction from his conjuncture—the environment of perfect competition in which all units of a commodity are homogeneous and available at the same price. (This is not the case under price discrimination adopted by a monopolist, for example.) So consumer’s surplus is a conjunctural gain.
Professor Nicholson, in his Principles of Political Economy, has raised objections to the notion of consumer’s surplus in the following words:
“Of what avail is it to say that the utility of an income of (say) £100 a year is worth (say) £1,000 a year.”
It can be answered by saying that there would be no avail in saying that. But there might be use, when comparing life in a remote, inaccessible village with life in a metropolis like Delhi. Suppose things which money will buy in the remote village may, on the average, be as cheap as in Delhi.
But there might be so many things which cannot be purchased in the village at all, so a person with a thousand rupees a month there is not as well off as a person with 3 or 4 hundred rupees a month in Delhi. Thus rupees 3 or 4 hundred plus the conjuncture of Delhi are worth, it may be said, rupees one thousand in a remote village.
Varshall’s consumer’s surplus has been subjected to a number of criticisms. It has been said that this concept is imaginary, laboured and unreal. Let us examine these criticisms:
(i) Laboured, Unreal and Imaginary: Marshall himself observes that “This analysis….appears at first sight laboured and unreal.” But in fact it is not so. It makes the meaning of a common saying in ordinary life clear that the real worth of things to a man cannot be gauged by the price he pays for them.
A person spends more on tea than on salt every month, for instance. From this we cannot conclude that tea is of greater real worth to him. This would be clearly seen if he is deprived of salt. In technical terms, it means that the marginal utility of a commodity does not indicate its total utility.
Generally, we fail to understand this because the price of salt is very low, so every one buys enough of it to satisfy his want. Consequently, an additional kilogram of salt brings little additional satisfaction, i.e., the marginal utility of salt is low. Since tea is costly, most people use less of it and their desire for it is not fully satisfied.
So its marginal utility is not as low as that of salt though its total utility is not as high as that of salt. Consumer’s surplus thus puts familiar knowledge in a firm, compact shape. It is, therefore, neither an imaginary nor a laboured nor even an unreal concept.
(ii) Difficult to Measure: Perhaps the most serious criticism of Marshall’s concept of consumer’s surplus is that there is no yardstick with which to measure it. Since utility is not quantifiable, so is consumer’s surplus as the difference between total utility and utility sacrificed in the form of price in order to acquire it. As we shall see below, Hicks has offered an analysis of consumer’s surplus that dispenses with the requirement of cardinal utility.
(iii) Constant Marginal Utility of Money: It is assumed, while measuring consumer’s surplus, that the marginal utility of money remains constant. It is again a wrong assumption. Marginal utility of money is not constant; it rather varies with the amount of money that one has.
(iv) Based on Unnecessary Assumptions: Marshall’s consumer’s surplus is based on many such assumptions which could have been avoided. He, for instance, considers the demand curve of one commodity only. It means that it is independent of the prices and quantities of other commodities. But it is not so. Similarly, this concept is based on the assumption of perfect competition which does not hold in real world.
“When Marshall’s principles was first published in 1890, his theory of Consumer’s Surplus was immediately recognised as the most striking novelty in the book.” says Hicks. But gradually opposition to this concept grew and gathered strength.
Economists of the older generation, such as, Walras and Pareto, Nicholson and Cannan, Knight and Robbins, began to lose faith in this concept. Consumer’s surplus, therefore, did not find any place in the text-books of economics for many decades. But with the development in the field of welfare economics in the 1930s and 1940s, there was a renewed interest in this concept.
This led to a rehabilitation of the concept of consumer’s surplus, by J.R. Hin in 1939 in his book value and capital.
(2) Rehabilitation by Hicks
In his book, Value and Capital, J. R. Hicks has presented an analysis of consumer’s surplus on the basis of ordinal utility. In doing so he has freed this concept from the unrealistic assumptions of measurable utility and constant marginal utility of income. His analysis is presented in fig.
In the figure it is assumed that the consumer has OM amount of money which he can spend on product X and other commodities. Indifference curve IC1 touches the Y-axis at M which means that all combinations of X and money on IC1 give the same satisfaction as the quantity of money, OM. It means that the consumer, in order to acquire ON of good X, is prepared to pay MS ( = FR) amount of money.
Since ML is the price line, its slope tells the price of X (i.e., price of X = OM/OL). The consumer is in equilibrium at P where the indifference curve IC2 touches the price line ML. At this point the consumer purchases ON of X by paying MQ and retains with himself OQ amount of money. It means that in order to acquire ON of X the consumer, on the basis of the market price of the good, has to pay only MQ (= FP) but was prepared to pay MS ( = FR). So RP ( = SQ) is the consumer’s surplus.
Hicks states that “RP is a perfectly general representation of consumer’s surplus, independent of any assumption about the marginal utility of money.” RP is not, however, necessarily equal to Marshallian consumer’s surplus; it will be so only when the marginal utility of money is constant and income effects are neglected.
But it is not legitimate to neglect income effects whose size dependents upon the proportion of income spent on a commodity-large in the case of a big portion of income spent on it and small in the case of a small portion of income spent on it. Hicks says that the theory of consumer’s surplus should include income effects. His concept of compensation variation in income is based on it.
Hicks has expressed consumer’s surplus as compensating variation income. He says that the best way of looking at consumer’s surplus is that monetary benefit which the consumer can get from a fall in the price of a good. A fall in the price of a commodity with unchanged money income causes an increase in the real income.
Now suppose that, with the decline in the price, consumer’s money income is so reduced that he comes back to his original position and is no better off than before. Such reduction in income is the compensating variation in income. It has been defined thus:
“The compensating variation is the maximum amount of income that could be taken from someone who gains from a particular change while still leaving him no worse off than before the change.”
As we noted above, Marshallian analysis of consumer’s surplus was open to the objection which is applicable to the whole of his theory of consumer demand. It rested on the assumption that utility was a measurable quantity.
J. R. Hicks has been able to show that the theory of demand based on ordinal utility and indifference curves could be used to redefine the concept of consumer’s surplus in terms of compensating variation in income. This way of defining consumer’s surplus has given rise to some confusion.
Henderson in his article “Consumer’s Surplus and Compensating Variation” has attempted to remove the confusion arising out of Hicksian analysis of consumer’s surplus. He has sought to clear the following two points:
(i) Marshallian consumer’s surplus and Hicksian compensating variation in income are the sums of money. These two sums will be equal only when the marginal utility of money is constant.
According to Marshall, it is that amount of surplus money which the consumer is prepared to pay rather than go without the good. In this case the consumer continues to consume the same amount of the good which he consumed earlier or none at all.
But Hicksian consumer is free to consume any quantity of the commodity. In this case the compensating variation in income is that additional monetary expenditure which the consumer is prepared to incur. Thus there is a limitation or constraint regarding quantity on the Marshallian consumer. There is no such constraint on Hicksian consumer.
(ii) Another point raised by Henderson is that compensating variation is not invariant, that is, it is not always the same amount. Reduction in money income in the event of the purchase of X will be different from the reduction in money income when X is not purchased.
On the basis of the above, Henderson has discussed four types of surpluses. Proceeding on this basis Hicks has developed four concepts of consumer’s surplus.
Four Concepts of Consumer’s Surplus
Hicks in his A Revision of Demand Theory accepts that he made a mistake in explaining consumer’s surplus in terms of compensating variation. He stated further that it is easy to commit mistake but very difficult to correct it. In an attempt to correct his mistake he explained his demand theory in the following two ways:
(i) Price-into-quantity Analysis: What quantity of a good is purchased at a particular price?
(ii) Quantity-into-price Analysis: What is the maximum price that can bepaid for a particular quantity of the good?
In order to understand the first we assume that buyers purchase in a perfectly competitive market. He is free to buy any quantity at a given price. In the second situation let us assume a rationing system where a consumer is required to pay discriminating price for each unit of the good or where a consumer is compelled to purchase a particular amount of the good.
Hicks states that the highest price that a consumer is prepared to pay for the consumption of a particular quantity of a good can only be known when he is not allowed to purchase less than this quantity. In other words, there is some limitation on the quantity of the commodity.
It is also to be noted that once the assumption of the constant marg! utility of money is given up, many explanations of consumer’s surplus : possible. Marshall ignored the income effect of a price change by assu constant marginal utility of money. But Hicks considers the income effect he differentiates between equivalent variation and compensating varias a price change.
The equivalent variation is the minimum amount that someone who gains from a particular change would be willing to accept to forego the change. The compensating variation is the maximum amount of income that could be taken someone who gains from a particular change while still leaving him no worse off than before the change. On this basis the following four types of umer’s surplus are discussed:
(i) Price Compensating Variation;
(ii) Price Equivalent Variation;
(iii) Quantity Compensating Variation; and
(iv) Quantity Equivalent Variation.
Recent developments in the field of economic analysis attempt to show that neither perfect competition nor comsumer’s surplus, compensating variation and equivalent variation are important concepts from the view point of economic policy.
According to Adolf Kozlik, no explanation of compensating variation is a true measure of consumer’s surplus. Samuelson is of the view that the measure of consumer’s surplus in the form of compensating variation is not useful. It is so because the benefits arising out of two given price situations cannot be compared with the benefits derived from other two price situations.
It is possible to explain all theories of tax incidence without measuring consumer’s surplus.
Consumer’s surplus suffers from all those weaknesses which apply to the theory of perfect competition. Like perfect competition, consumer’s surplus is also based on the following assumptions which do not permit the theory to be useful in practice:
- independent existence of commodities without complementarity or substitution; and
- the equality of price and marginal cost.
In reality consumer demand is subject to many types of uncertainty. So no consumer can have definite knowledge about his preferences.
Usefulness or importance of the Concept of Consumer’s Surplus
In spite of the several serious shortcomings of the concept of consumer’s Surplus, it cannot be denied that it is useful in several respects.
(a) It brings to the fore the difference between value-in-use and value-inexchange of a commodity. Price is not the true measure of value-in-use of a commodity. This is clear from the analysis of consumer’s surplus. Thus it solves the paradox of value.
(b) The concept is useful in helping to evaluate many government decisions. Thus it is of importance in cost-benefit analysis needed in the selection of government projects, particularly big, indivisible projects.
(c) It also points to the enormous privilege enjoyed by citizens of modern societies.
(d) It is useful in taxation. Commodities which are generally better for taxation are those which yield large consumer surpluses. They have low elasticities. So their sale will hardly be affected by tax-induced price rise. It can be used to decide which commodities to be given subsidies.
(e) A monopolist practising price discrimination finds this concept useful. It is easier to raise prices of those units which yield surplus satisfaction. But prices should not be raised so high as to take away the entire surplus.
(f) This concept is useful in measuring the benefit from international trade.
(g) The concept of consumer’s surplus has been widely used in welfare economics. Marshall made use of this concept to examine the effect of a tax or subsidy on welfare.
Reallocations of resources affect individual’s welfare. We want to know not only whether such changes make people better off or worse off but also by how much. Consumer surplus is a tool for obtaining such a measure. Suppose that, before any reallocations of resources take place the price of commodity X was OP and consumer surplus was the triangle DP1Q1 under the demand curve DD’ and the price line P1Q1.
Now assume that as a result of reallocations of resources, a larger production of X takes place and its price falls to OP2. Consumer surplus is still the area under the demand curve DD’ and the horizontal line at the going price which is now OP2. The relevant area showing the consumer surplus is now DP2Q2. It shows that consumer surplus has increased by the area P1P2Q2Q1. So the consumer is better off consequent upon the reallocations of resources. In other words, consumer welfare has increased. All this has been illustrated in Fig.
Consumer’s Surplus and Producer’s Surplus
Marshall, in Appendix K of his Principles, analyses certain kinds of surpluses. He says that though national income is completely absorbed in remunerating the owner of each agent of production at its marginal rate, yet, it generally yields him a surplus which has two distinct, though not inde pendent, sides.
As a consumer he gets a surplus consisting of the excess of the total utility to him of the commodity over the real value to him of what he paru for it. It is a true net benefit which he, as a consumer, derives from the facilities offered to him by his surroundings or conjuncture.
Another side of the surplus which a man derives from his surroundings better seen when he is regarded as a producer. As a producer he gets producer surplus. This surplus occurs because all units of each firm’s output are sold the same market price, while, given a rising supply curve, each unit except the last is produced at a marginal cost that is less than the market price. Producer’s surplus is defined as the amount that producers are paid for a product less the total variable cost of producing the product.
The two surpluses are shown in Fig. In the Figure, Consumer’s surplus is the area under the demand curve and above the market price line, that is, the area PEL. Producer’s surplus is the area above the supply curve and below the market price line, that is, the area PEK.
The equilibrium price and quantity are OP and OM respectively. The total satisfaction that the consumer expects to get from OM quantity is OLEM, while the total amount that he really pays is OPEM. The difference between them, that is, the area PLE is consumer’s surplus.
The receipts from the sale of OM of X that the producer receives are OPEM, the amount that the consumer pays for OM of X. The cost of producing the OM quantity is the area under the supply curve, KS, that is, the area OKEM. The difference between the two is producer’s surplus, that is, the area PEK.
Marshall divides the producer’s surplus into two parts, namely, the worker’s surplus and saver’s surplus. A producer supplies either direct labour surplus through being remunerated for all his work at the same rate as for that last part which he is only just willing to render for its reward while much of saver’s surplus through being remunerated for all his saving (involving waiting) at the same rate as for that part which he is only just induced to undergo by the reward to be got for it.