When analyzing changes to a consumer optimum given changes
in the market price of a particular commodity, we often speak of the consumer
being better or worse off. What is missing in this analysis is the ability to
quantify changes in individual satisfaction due to these price changes. One
method used to measure these welfare changes is through the use of a concept
known as Consumer Surplus. This method compares the value of each unit
of a commodity consumed against the price of that commodity. Stated differently,
consumer surplus measures the difference between what is person is willing
to pay for a commodity and the amount he/she actually is required to pay.
Consumer demand is a measure of willingness to pay. As shown in the diagram
below, consumers often value each additional unit consumed less that previous
units (i.e., the concept of diminishing marginal utility). For example, suppose
that the good in question is monthly consumption of gasoline. Based on the data in the
diagram below (left), the consumer would be willing to pay $9 for the first
gallon rather than to without. This first gallon would be used for essential
driving activities. Each successive gallon has a value to the consumer of $1
less than previous units (2nd gal = $8.00, 3rd gal. = $7.00,
and so on) as
needs are met and the consumer engages in driving more for pleasure and
sight-seeing. The value that the consumer places on each gallon (unit) consumed
is summarized by the individual Demand curve
as shown in the diagram on the right.
figure 1 -- Diminishing Marginal Value
Consumers do have a choice in the purchase of gasoline or other goods.
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 represents
the reward to consumers for participating in the market place.
If the market price of gasoline were $4.00 (for each and every gallon --
the seller not being able to determine the value of each gallon sold),
the consumer would buy 6 gallons per month (see figure 2 below left).
figure 2 -- Consumer Surplus
In the diagrams above, we find that with a market price Pmkt of $4.00 per gallon
and quantity demanded equal to 6 gallons, the total value of consumption is $39.00
($9 + 8 + 7 + 6 + 5 + 4). Part of this value is given up in the form of total
expenditure equal to $24.00 ($4 x 6gal) as shown by the
gray-shaded area in the
right diagram. The difference of $15.00 ($39.00-$24.00) represents consumer surplus
as shown by the cross-hatched colored bars in the right diagram.
These measures of total expenditure and consumer surplus can neatly defined
as geometric areas below a given demand curve. In the diagram below, the colored
bars have been replaced with shaded areas allowing for divisibilities in consumption.
Rather than restricting the consumer to purchase of 1, 2, 3, ... gallons, we now
allow that individual to be able to purchase fractions of a gallon.
figure 3 -- Consumer Surplus
We can use this measures to quantify the welfare effects of a
change in market price by examining the corresponding changes in
For example, suppose that in the above example, market price increases
to $6.00 perhaps due to an increase in excise taxes. At this higher price,
the consumer would be willing to purchase only 4 units of this product. In
purchasing these 4 units, the consumer receives $30.00 worth of value
($9.00, $8.00, $7.00, $6.00) and spends $24.00 ($6.00 x 4 units). The
difference of $6.00 is the new level of consumer surplus.
figure 4 -- A Change in Market Price
By measuring the change in consumer surplus, we can begin to quantify the
change in consumer welfare from the increase in gasoline prices:
CSbefore = $15.00
CSafter = $6.00
ΔCS = -$9.00
The $2.00 increase in the price of gasoline has led to a $9.00 reduction
in consumer welfare.
Using the tools of indifference curve analysis, we can demonstrate
that in increase in market price indeed makes the consumer worse off.
By measuring the changes in consumer surplus, we can define how much worse
off the consumer has become - a useful empirical tool for policy analysis.
Concepts for Review:
- Consumer Surplus
- Total Expenditure
- Total Value (of Consumption)
- Economic Welfare