Explain what is meant by the term "consumer surplus" and show how changes to individuals' consumer surplus, as a result of price changes can be derived from indifference curve analysis.

University Degree Business and Administrative studies

Lee Josephs I.D 316759

Economics Essay

Explain what is meant by the term "consumer surplus" and show how changes to individuals’ consumer surplus, as a result of price changes can be derived from indifference curve analysis.

Economics can explain the reason why the rational economic man will consume varying levels of different commodities by applying supply and demand theory. When a consumer purchases a good, then utility is gained. The rational consumer weighs up the costs and benefits for each additional unit of a specific good purchased. Utility is therefore the key element when a consumer buys any good or service. When a consumer buys an additional unit of any good, his total utility will increase. However the increase in utility per each additional unit is not as high as the previous purchase. The consumer shall therefore continue to buy the good until there is no additional utility gained. This can otherwise be explained as the principle of diminishing marginal utility and at this point, marginal utility is equal to the price paid, we are therefore at the equilibrium where (MU=P).

We therefore understand that consumer demand is a measure of willingness to pay and that consumers are often willing to pay an amount higher than market price for a commodity rather than do without it. However, for each successive unit consumed, the amount the consumer is willing to pay decreases.

Following on from this point it is evident that a consumer's surplus represents a reward to a consumer for participating in the market place. Consumers do have a choice. Either they could avoid market participation and spend nothing and receive nothing of value or they can purchase a certain quantity of this good and receive value over-and-above the market price.

Consumer surplus is therefore based on the theory of diminishing marginal utility. In this way the area between the demand curve and the equilibrium price is recognised as the consumer surplus. An individual’s consumer surplus can be calculated by using the following equation;

Consumer Surplus = Total Value – Total Expenditure

The end result is a measure of the individual’s level of satisfaction gained (utility) and consumer welfare. The following is graphical representation of what I have discussed so far.

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Consumer Surplus = Total Value – Total Expenditure

The end result is a measure of the individual’s level of satisfaction gained (utility) and consumer welfare. The following is graphical representation of what I have discussed so far.

The above diagram shows the consumer surplus for an individual buying six units of a particular good. The total value of consumption is $39, and total expenditure is $24. The difference represents the consumer surplus of the individual. Using this measure of consumer welfare to quantify the effects of a change in market price. If the market price is increased to $5 then there is a significant difference in the individual’s consumer surplus. The consumer is less willing to buy as many units of the good. The consumer’s welfare will reduce as a result of the increase in the market price.

The economic rational man shall always prefer variation. Variation is an essential element for the concept of utility maximization.

Max U = f(x,y)

The units in brackets represent measurable quantities of goods and services. As Economists we use individual preferences for goods and services to indirectly represent the utility gained from consumption of these items. We shall make the assumption that individuals make rational free choices and have preferences, more is preferred to less, however the principle of diminishing marginal utility is still applicable. By making these assumptions several conditions are satisfied. We ensure that our preferences are complete and that non-satiation applies. The last assumption states that consumers prefer combinations of goods and services that contain some variety of those goods rather than extreme bundles that contain large amounts of just one particular good. This is the concept of diminishing marginal utility or the principle of variation

Using the tools of indifference curve analysis, it is possible to demonstrate that an increase in market price does make the consumer worse off. However a decrease in the market price will have the opposite effect, it will increase the individuals’ disposable income, therefore making him/her better off. By measuring the changes in consumer surplus, it is possible to define how much better or worse off the consumer has become.

Combinations of goods can be made up of either economic goods, goods that are desired by the consumer, or economic bads, those that are not desired. An individual may feel indifferent about the combination of any two goods, when this is the case the two bundles provide equal levels of satisfaction. For example two different bundles of apples and oranges provide the same level of utility to the consumer. Another example is that of books and movies, the diagram below clearly shows different bundles that provide equal levels of satisfaction. For example the same level of satisfaction is gained on the same indifference curve, however the different curves have different levels of utility gained.

The fact that the indifference curves are downward sloping indicates that the assumption that more is preferred to less is true. Movements in the curves from IC0 to IC1 indicate that the consumer shall become better off. Therefore on a diagram for consumer surplus, we will see that it shall increase.

A consumer optimum represents a solution to a problem facing all individuals maximizing the satisfaction from consuming different goods and services subject to the constraint of household income and product prices.

In this problem, the objective function is unobservable leading to the use of assumptions about consumer preferences and diagrammed through the use of indifference curves. From our understanding of the utility function and utility surface we can derive the slope of an indifference curve as:

The Marginal Rate of Substitution = MRSxy = MUx/MUy

This budget set represents all combinations of the two goods that are attainable to the consumer given his level of income and the market-determined prices of these goods. Second, we can write it as a budget constraint expressed as an exact equality in intercept-slope form:

The slope of this budget constraint is a relative price (the price of good-x relative to the price of good-y) where a change in any price, either in absolute or relative terms, will lead to a rotation of this constraint.

In the diagram below, we see the effects of changes in market price. In the case of a decrease in the price of good ‘x’ the budget line rotates outward and the price ratio declines (good-x is less expensive in absolute and relative terms, good-y is more expensive in relative terms). This outward rotation also leads to an increase in the size of the budget set such that the consumer should be better off. We find that with this particular price change, the consumer is buying more of good-x and more of good-y as defined by a new consumer optimum at point T.

Increase in Price X Decrease in Price X

Having demonstrated above how a change in price affects the position of the budget line. It is now possible to demonstrate how as a result of a price change the individual’s consumer surplus changes. In order to do this it is necessary to introduce the price consumption curve.

Firstly the price consumption curve shows the relationship between the quantity of goods bought and the price of the good whose price has changed as long as everything else remains “ceteris paribus.” The price consumption curve is the line that joins up the points of optimum consumption on each indifference curve; these points are clearly marked by the tangent created by the budget line. Using the price consumption curve, it is possible to create a demand curve for the change in the market price of the good.

A comparison of the two demand curves, each one representing the demand curve with the original price and then the second representing the change in price, will determine how much the individuals consumer surplus has changed and whether he /she is better off. If only one good has increased in price the consumer shall be worse off if there is no change in income because the consumer can now only afford to buy less of each good.

Therefore in conclusion, it is evident that a change in the market price affects the consumers buying position and his/hers consumer surplus. The result of a price change in one good shall cause the consumer surplus of an individual to decrease. The result of a decrease in price, shall increase the consumer’s income, and therefore cause an increase in consumer surplus. There has only been a change in price, therefore the effect can only be a substitution effect. The consumer therefore buys more of the cheaper good, but due to an increase in purchasing power as a result of the change, the consumer will now buy more normal goods as opposed to inferior goods.

There are other factors that cause consumer surplus to be affected. These changes are due to market failures and imperfections. For example market power, if a firm comes to dominate the market then it can lead to higher prices and lower levels of output therefore a loss in welfare. Other factors include factor immobility and inequality.

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