Consumer surplus is the excess of the price of which a consumer is willing to pay (demand price or value-in-use) for the commodity over and above, what he actually pays (market price or value-in-exchange) for it.
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It implies the net gain or benefit which a consumer enjoys by consuming one market basket instead of another.
1. Marshallian Consumer Surplus:
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Marshall formulated the concept of consumer surplus on the basis of law of diminishing marginal utility. On account of the operation of this law, the consumer is willing to pay lesser and lesser price of each successive unit of the commodity.
However, the consumer pays the same price for all the (similar or homogeneous) units of the commodity. This indicates that the consumer gets extra utility over the price paid by him for all earlier units.
The sum of all these extra utilities is called the consumer surplus. As for the last unit consumed price equals the marginal utility (equilibrium condition), no consumer surplus is received by the consumer from the marginal unit. This is illustrated in Fig. 5.54 by the shaded area.
Consumer Surplus in Fig. 5.54 is computed as under
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= Aggregate Willingness Price-Total Actual Price
= Total Benefit – Total Payment
= Area under MU curve – Price x Quantity = Area (OABQ – OPBQ) = Shaded Area APB
Consumer Surplus rises when price falls and vice-versa. Further, price of those commodities can be easily increased on which consumers enjoy a high amount of surplus. Monopolist has to see the amount of consumer surplus while fixing pricing under price discrimination.
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This concept can be used to resolve diamond water paradox. The total benefit from consuming water is very high since it is essential. But, its marginal’s is very low as it has abundant supply. Thus, water has low price and large consumer surplus. On the other hand, diamonds are scarce in supply and have high price. Thus, consumer surplus from diamond is low.
2. Hicksian Consumer Surplus:
Hicks used indifference curves to depict consumer surplus. While Marshallian Consumer Surplus is equal to the area between the demand curve and the price line. Hicksian consumer surplus is equal to the vertical distance between the indifference curves. Hicks has given better measure of consumer surplus as it neither assumes cardinal utility nor constant marginal utility of money.
Measurement of consumer surplus with the help of indifference curves technique (with constant marginal utility of money) is illustrated in Fig. 5.55. In this figure, the quantity of commodity ‘X’ is measured along the X axis, while money income is taken along the Y axis.
Suppose, a consumer has OA amount of money income, which he can spend on commodity ‘X’ or other commodities. The consumer is indifferent among various points on the indifference curve IC1 through point ‘a’. This indifference curve shows the amount of money, the consumer is willing to pay for commodity ‘X’ at its different quantity levels.
Since the scale of preferences of the consumer represented by his indifference curves depend on his tastes and not on his income or market price of the commodities, the budget line is not relevant here. Now, if the consumer selects point ‘E’ on the indifference curve IC1, he is willing to give up AD amount of money income to get OC quantity of commodity ‘X’ rather than do without it.
In other words, OD amount of money and OC quantity of commodity ‘X’ give same satisfaction to the consumer as OA amount of money, as both ‘A’ and ‘E’ combinations lie on the same indifference curve IC1.
Suppose that the market price of commodity ‘X’ is such that we get AB budget line. Price of commodity ‘X’ is given by slope of this line, i.e. OA/OB. Given this price of commodity ‘X’, the consumer is in equilibrium at point ‘F’, where the budget line AB is tangent to indifference curve IC2. Since point F’ is on a higher indifference curve IC2, the combination of money income (OG) and quantity of commodity ‘X’ (OC) at this point represents a higher level of satisfaction as compared to any point on IC1, indifference curve.
Here, the consumer gives up AG amount of money to acquire OC quantity of commodity ‘X’, Therefore, the consumer pays EF (or DG) less amount of money than what he is prepared to pay (AD) for OC quantity of commodity X’. Thus, AD – AG = DG (or EF) is the amount of consumer surplus from purchasing OC quantity of commodity ‘X’. This shows that consumer surplus is equal to the vertical distance between indifference curves.
The Marshallian consumer surplus measured so far by using indifference curves assumes constant marginal utility of money. So, the indifference curves IC1 and IC2 will be parallel to each other and have the same slope at any given quantity of commodity ‘X’.
This implies that income effect of the price change on the quantity demanded is zero, so that the amount of money that the consumer is prepared to pay for a commodity rather than go without it does not change, as the money income is given up to obtain the larger quantity of the commodity.
Assuming marginal utility of money income equal to one, it can be shown that the slope of indifference curve IC1 is same as the slope of indifference curve IC2 for OQ quantity of commodity ‘X’.
