Consumer Surplus Theory - Essay Example

?Consumer Surplus Theory Outline Consumer Surplus is the difference of paid market price and the maximum price a is inclined to pay for a particular product (Dooley, 1983, pp. 27 - 29). “Consumer Surplus arises because we receive more than we pay for” primarily due to law of diminishing marginal utility” (Samuelson & Nordhaus, 2005, p. 96) The theory is used by government to evaluate how effective its policies are and how their implementation will lead to societal welfare (McConnell & Brue, 2002, p. 459) 1. Introduction I would like to start this paper by recalling the definition of Microeconomics – a branch of economics that deals with the economic behavior of households, individuals, businesses and governments. The first major insight that students obtain from the study of microeconomics is the theory of demand and supply. Nevertheless, the demand is the willingness and ability of individuals of consumers to acquire certain goods and services. Therefore, when prices increase (assuming determinants of demand constant) the quantity demanded decreases and vice versa, thereby resulting in a downward sloping demand curve due to negative price – quantity relationship. In contrast, the supply refers to willingness and ability of sellers to produce and sell certain goods and services. Hence, when prices increase (assuming determinants of supply constant) the quantity supplied also increases because of increase in profit margin of producers and vice versa. In simple words, the supply curve slopes upward due to positive price – quantity relationship. In this paper, I would elucidate on Consumer Surplus – a theory contributed by Alfred Marshall in 1920s (and derived by using the downward sloping demand curve) that initially received various serious criticism by then economists and academicians. Dooley (1983, p. 26) has summarized the following major criticisms raised at that time - “First, whether an additive utility function adequately explains consumer behavior; second, whether the marginal utility of money can be treated as a constant; third, whether the quantity demanded of one commodity can be treated as a function of its price alone; and fourth, whether it is possible make interpersonal comparisons”. The researcher will first explain what Consumer Surplus theory is after which an analysis will be presented on the credibility of this theory. The researcher will conclude this paper by providing a personal opinion and will finally provide 2 recommendations to the economists and pundits. 2. Analysis / Body Consumer Surplus is a concept studied in microeconomics and it refers to the estimation of consumer utility. In simple words, consumer surplus is the surplus portion calculated by subtracting the maximum price consumer wants to pay for acquiring a good or service with the equilibrium market price. This could also be defined as the difference between the actual paid market price and the highest price at which demand of a product exists. As illustrated in Figure 1, the equilibrium quantity and price are P1 and Q1 respectively; however, the demand of a product also exists at higher prices. Therefore, the blue portion represents consumer surplus. Figure 1 In order to fully comprehend the theory of Consumer Surplus, I would like to present an example of demand of DVDs (video games) relative to their price. In this case, let us consider that a consumer enters in a Computer shop to buy video games. The consumer buys 10 DVDs of $50 in total but he is inclined to pay $95 for one DVD so the consumer’s surplus for 1 unit will be $45, for 2 units will be $40, for 4 units will be $30, for 6 units will be $20, for 8 units will be $10 and for 9th unit will be $5 only. The figure 2 illustrates the consumer surplus in green, which is below the market demand curve and above the equilibrium market price. Figure 2 Samuelson & Nordhaus (2005, p. 96) highlights the following: “Consumer Surplus is the gap between the total utility of a good and its total market value” It arises because we receive more than we pay for” primarily due to law of diminishing marginal utility”. It is worthwhile to mention the fact that consumer surplus occurs because the buyer has inclination to pay the same amount for the first unit as well as for the last unit it agrees to buy. In my example, the 10 DVDs will cost $50 so the consumer is paying $5 for each DVD. Nevertheless, the law of diminishing marginal utility maintains that the utility that a consumer will receive on playing first video game (1st DVD) will be greater compared to the satisfaction and entertainment he is going to receive after playing second video game but monetary price paid for each game remains same. Hence, the marginal utility reduces with consumption of each additional unit. In other words, the consumer will enjoy the surplus of utility on each of the earlier played video games. As far as the application of consumer surplus in real life is concerned, it should be emphasized that this is not a theoretical topic rather governments utilize the theory when setting budgets for Public Sector Development Program (McConnell & Brue, 2002, p. 459). For instance, the policy makers of USA could estimate quantitatively how the construction of premium quality roads would help securing lives of citizens. Indeed, if the construction budget is set as $100 million and the road ensures safety of 15 lives (assuming a life’s value is 9 million) then the consumer surplus in this case will be $35 million. In short, government could also reduce its healthcare budgets by spending more on road construction. 3. Conclusion In a nut shell, I would like to pinpoint that consumer surplus theory could be used in real world scenario; however in my opinion, the theory would remain beneficial only when statisticians and finance specialists made a near-to-accurate costs and benefits analysis. Considering the aforementioned example, if statisticians’ initial estimation of 15 lives proves wrong and accidents increase (lives lost) then entire decision-making and problem-solving process have to be reinitiated for amending implemented policies followed by revision of budgets and expenditures. Hence, the theory’s practical success is heavily dependent upon accuracy and glib expertise of mathematicians / finance personnel. According to my understanding, the approach is theoretically sound as it could be used for further research. 4. Suggestions My first recommendation to future researchers is to investigate how consumer surplus theory could be applied by underdeveloped countries for technological innovation. My second recommendation to future researchers is to investigate how consumer surplus theory could be applied by government of a developed economy in providing maximum relief to an ordinary citizen during financial crises. In short, my suggestions are more about covering the practical side of the theory rather simply discussing the criticisms of theorists and economists. References Vives, Xavier. “Small Income Effects: A Marshallian Theory of Consumer Surplus and Downward Sloping Demand” Review of Economic Studies, 1987, pp. 87-103 Dooley, Peter. “Consumer’s Surplus: Marshall and his critics” The Canadian Journal of Economics, Vol. 16, No. 1, 1983, pp. 26-38 Samuelson, William & Paul Nordhaus “Economics” McGraw-Hill Irwin, 18th Edition, 2005 McConnell, Campbell and Stanley Brue “Economics: Principles, Problems and Policies”. McGraw-Hill Irwin, 15th Edition, 2002 Read More