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CONSUMERSS SURPLUS

Consumer surplus (CS) The concept of consumers surplus was developed by Marshall in the
1890s. Marshallian defined consumer surplus as the difference between potential price actual
price. It is the excess price that the consumer is willing to pay for a commodity over that which
he actually pays, rather than go without the commodity. Marshall in 1890 suggested that
consumer's surplus could be measured by the area under the demand curve. It is the difference
between the total amount that consumers are willing and able to pay for a good or service
(indicated by the demand curve) and the total amount that they actually pay (the market price).

The consumer surplus is WTP less the amount actually paid. Actual amount paid is given by the
area m + n (price times quantity purchased). Graphically CS is the triangle marked a+b+c. In
some way, it measures the 'benefit' the consumer obtains from consuming x0 at p0 price. The CS
is the area under the demand curve but above the price line.
Often, we measure the change in CS, for example as a result of a price change. This tells us
whether a consumer becomes better or worse off and by how much. Suppose the price of x rises
from p0 to p1 as in the figure. Demand falls from x0 to x1. The consumer's surplus before the
price rise is the triangle marked a+b+ c . The consumers surplus after the price rise is the triangle
marked a. The change in consumer's surplus is therefore the area b+c. This is the sum of:
the

area b - this is the loss due to the fact that the consumer now has to pay more for the x1 units

he continues to consume.

the

area c - this measures the value of the x0-x1 units that are no longer consumed. In other

words it measures how much these lost units were worth to the consumer.

J.R. Hicks Method of Measuring Consumers Surplus


Prof. J.R. Hicks and R.G.D. Allen have used indifference curve approach to
measure consumers surplus. Prof. J.R. Hicks and R.G.D. Allen are unable to
accept the assumptions suggested by Marshall in his version of measuring
consumers surplus.
According to these economists, the assumptions are impracticable and
unrealistic.
According to Prof. J.R. Hicks and R.G.D. Allen,
1.

Marginal utility of money is not constant. If the stock of money


decreases, the marginal utility of money will increase.

2.

Utility is not a measurable entity but subject in nature. Hence, it


cannot be measured in cardinal numbers.

3.

Utility derived from a unit of a commodity is not independent. Instead,


utility is related to previous units consumed.

In the figure given below the horizontal axis measures commodity X and
vertical axis measures money income. Assume that the consumer does not
know the price of commodity X. This means that there is no price line or
budget line to optimize his consumption. Therefore, he is on the combination
S on indifference curve IC1. At point S, the consumer has ON quantity of
commodity X and SN amount of money. This implies that the consumer is
willing to spend FS amount of money for ON quantity of commodity X.

Now assume that the consumer knows the price of commodity X. Hence, he
can draw his price line or budget line (ML). With the price line (ML), the
consumer realizes that he can shift to a higher indifference curve (IC 2).
Therefore, the new moves to the new equilibrium (point C), where the price
line ML is tangent to the indifference curve IC 2. At point C, the consumer has
ON quantity of commodity X and NC amount of money. This implies that the
consumer has spent FC amount of money on ON quantity of commodity X.
The consumer has to spend only FC amount of money instead of FS to
purchase ON quantity of commodity X. Therefore, CS is the consumers
surplus.
Measuring C S using Hicksian

indifference curves attains results without

Marshalls doubtful assumption. Hence, it is considered to be superior to that


of Marshalls method.

Problems with the Marshallian approach to consumer surplus


ZUnderlying the CS concept is a constant MU of income. Hicks held that we should measure the
area under a constant real income demand curve, not a constant money income one. That is we
need to remove the income effect of the price change and concentrate on the substitution effect.
Compensating and equivalent variations: theory
Based on Hicksian methodology we can explain four concepts of consumers surplus.

Price compensation Variation

Quantity Compensation variation

Price Equivalent Variation

Quantity Equivalent variation

Price Compensating variation is the maximum amount of money the consumer is willing to
pay (after the price change) to be as well off as before the price change. It is the maximum sum
of money that the consumer is willing to pay for the opportunity of buying at a lower price and
be atleast as well off as he was before the price change.

The figure shows that the consumer is originally on IC1. In the event of fall in the price of the
good he will move to IC2, a higher indifference curve. However if the consumer has to pay a
certain sum to enjoy the opportunity of buying at a lower price, then after the payment of the said
amount, the consumer should atleast be on IC1. MN is the Compensation Variation amount in the
figure drawn above.
The Hicksian Equivalent Variation Measure of Consumers Surplus
Price Equivalent variation is the minimum amount of money, the consumer will agree to accept
for foregoing the opportunity to buy at a lower price and be as well off as he would be with a
price fall. This represents the amount by which the consumer's money income would have to be
increased after the price change to put him on the higher indifference curve. In the figure AC is
Equivalent Variation.

QUANTITY AND COMPENSATION & EQUIVALENT VARIATION


Quantity Compensation Variation and Quantity Equivalent Variation are the same as Price
Compensation Variation and Price Equivalent Variation respectively except that they involve a
quantity constraint in addition to the utility constraint.

QUANTITY COMPENSATION VARIATION


Quantity Compensation variation is the maximum sum that the consumer is willing to pay for
the opportunity of buying at a lower price consumer and enjoy the original level of welfare after
the payment and also be able to buy the same quantity that would be bought at the new lower
price.
a. The consumer retains the original level of utility after the paymentof the said amount.
b. He buys the same quantity that he would buy at the lower price.
Thus there are two constraints a utility constraint and a quantity constraint. It should be noted
that while the utility constraint is related to the utility at the original higher price level, and the
quantity constraint is related to the new lower price level. In the following figure, cd is Quantity
Compensation Variation. PCV is MN = ce. Clearly PCV > QCV. ( ce >ed)

QUANTITY EQUIVALENT VARIATION


Quantity Equivalent Variation is the minimum sum that the individual is willing to accept for
foregoing the opportunity of buying at a lower price, such that, after receiving the said amount
a. He retains the level of welfare associated with the new lower price

b. He buys atleast the quantity associated with the original higher price.
In the following figure ad is quantity equivalent variation,( QEV ) .

In the figure PEV = CA =ak. And QEV is shown as ad. Clearly QEV > PEV, that is ak > ad. The
consumer needs to be paid a greater sum since there is an additional constraint.