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11

fig. ix diamonds

. Consumer Surplus

placed on consuming die very last unit. The price of aonds, like the price of water, excellently measures [ value we place on consuming the last bit that we y. Water is reladvely abundant, so the price of water ivery low. As such, we buy a great deal of water and ace a very low value on consuming the last drop, usu- only a fraction ofa i)enny. On the other hand, dia-»nds are relatively scarce and sell for high prices. :refore, we consume few of them and place a very high value on the last one consumed, usually hun-1 of dollars. For example, the authors would sub-ely value having an additional ounce of diamonds auch more than we would value having an additional S>unce of water. Figures IX and X, showing the demand for diamonds and water respectively illustrate these .As depicted, the market price of diamonds is rel-Jatively high, so the subjective value or marginal benc-it (MB) of the last diamond bought is also high, lowever, the price of the last diamond or last bit of jwater bought tells us nothing about the subjective value placed on any of the other units purchased. iTheir subjective value and cost must be also be consid--ered if we are to evaluate the total net benefits from consuming the two goods.

As the difference between what goods are subjectively worth to consumers and what they have to pay, consumer surplus captures these total net benefits, which arc also termed the consumers gains from trade. Thus, in Figures IX and X, the consumer surplus of diamonds is very small relative to that of water. Lacking the consumer su lus concept, the classical economists went wrong by trying to capture the total benefit of W3.ter.and diamonds with their respective prices.

In short, when we want to measure the value

people place on having another unit of a good, we consider the price they are willing to pay for it. In other situations, when we want to know consumers net gains from trade or their total welfare, we look to their consumer surplus.

Oftentimes economists seek to measure how changes in government policy affect consumer welfare. In such situations the use of consumer surplus is almost routine. As just one example, to illustrate the power of the concept, suppose the Food and Drug Administration is considering a new set of drug testing standards which will make drugs both safer and more expensive. By itself, improved drug safety, improves consumer welfare; on the other hand, the net impact of higher prices, taken alone hurts consumers. The ultimate question is, of course, whether consumers will be made better or worse off. The consumer su lus concept allows us to attack such questions analytically.

Suppose in Figure XI that initially the demand for drugs is given by the demand curve Dj and the price by Pj. (You can ignore the curve Dj for now.) Then the consumer surplus consists of the "triangle" above the price line Pj. Breaking that area into two parts, we see it is the sum of areas 1 and 2. Now if the testing program makes drugs safer, people would be williilg to pay higher prices for drugs. As such, the demand for drugs would increase from D j to D2 in the figure. On the other hand, the price now rises from Pj to P2 so that the new consumer surplus consists of the triangle bordered by the price line p2 and the new demand curve Dg- This "triangle" is composed of the areas 1 plus 3. Comparing the two consumer surpluses, we see that area 1 is captured in both situations and that the consumer loses area 2, but gains area 3 under

fig. x water



Demand

Fig. XI

The Use of Consumer Surplus

Fig. XII

\s 3

Increased Consumer Wellare

2 \

Decreased Consumer Welfare

the regulatory change. Smce in Figure XI, area 3 exceeds area 2, we can see that consumers are better off. On the other hand, if we had the situation in Figure XII, consumers would be worse off because area 3 is smaller than area 2- In short, we can analytically measure the impact of a pohcy or price change on consumer welfare by checking whether consumer 5 ] 5 rises or falls.

DEMAND AND UraJTY

Although the law of demand is plausible at face value, it is derivable from two postulates regarding consumer behavior. First, given their limited money income, consumers seek to allocate their purchases among the many competing goods so as to maximize their total satisfaction, which we term utility. Second, as the consumption of any particular good per unit of time increases, the utility derived from successive uniu of that good diminishes. The utihty derived from consuming an added unit of a good is known as its maral utility, and the second postulate is referred to as the assumption of diminishmg marginal utility.

For example, consider Freds consumption of Belgian waffles on any particular day and assume that we can measure Freds satisfaction or utility in units of "utils." Then the hypothesis of diminishing marginal utility can be illustrated in a table such as Table FV. As shown, one waffle consumed daily yields Fred a total utility of 8 utils, while two yields a total utility of 12. Therefore, the second waffle yields an additional or maial utihty of 4 utils (12-8). Sunilarly, the margmal utihty of the third waffle is 2 udls (14 -12).

It can readily be seen that the marginal uuHty of an addidonal waffle is simply the change in total

utility obtained by consuming one more waffle. Thej Table also depicts our assumption that marginal utility] (MU) declines as consumption rises. By the 5th wafQel MU becomes zero, meaning that Fred wotdd neither! gain nor lose satisfaction from eating it Thereafteri MU becomes negative, so that fiirthcr consumptionj becomes unpleasant

One point you should definitely notice: so long] as marginal utility (MU) is greater than zero, Fredl gains total utility by further consiunption. This makesj sense: so long as additional consumption gives himj some utility, however small, he gains total utility consuming more. Only when the added utility act becomes negative, that is to say, only when MU < 03 does total utility startto fall. Thus in Table IV, total util ity would Stan to fall from its maximum possible valt of 15 utils if Fred eats a 6th waffle.

If waffles were free, then Fred would maxir

Table IV Freds Total & Marginal Utility From Daily Waftel Consumption

Wattles Cousumed TotalUlijity &



iDemand

his total satisfaction by consuming to the point where he gets no added utilit) from further consumption. This is another way of saving hed consume undl marginal utility is zero. In Table MU = 0 at fwe waffles per day. Consequently, Fred would eat only five waffles even if they were free. In the real world, however, waffles must be paid for and Fred will want to allocate his limited income among alternadve goods so as to maximize his total utilit). How should he proceed?

Suppose that Fred has $10 per week to spend between just wo goods, beer and pizza priced at $1 Pand $2 respecuvely, and let the utility derived from beer and pizza be given in Table V. The first through third columns and the fifth through the seventh owing the totzil and marginal utilities of beer and ipizza are familiar. As in the previous table, the total itility obtained by consuming these two goods rises so yng as MU>0. The only new aspect occurs in the purth and eighth columns, marked as the marginal itility per dollar spent. This requires a bit of explana-1. Consider the amount of pizza Fred can buy for That amount must be Sl/Pp where Pp is the price jizza. For example, if the price of pizza is $2, Fred buy V2 pizza ($l/$2) for a dollar Muldplying a iollars worth of pizza, (1/Pp) by the marginal udlity pizza (MUp) gives back MUp/Pp, the marginal udl-[)er dollar spent on pizza. For example, column 3 s the marginal utilit) of the first pizza (MUp) as 16 per pizza. Therefore, spending a dollar on pizza lows Fred to buy 1/2 pizza, for a udlit) gain of 8 utils dollar [(16 udls/pizza) (1/2 pizzas/dollar)]. In ler words, 8 utils per dollar represents the marginal ity i)er dollar spent on the first pizza, our first entry I "Column 4. All other entries in columns 4 and 8 are imilarly derived.

Since Fred wants to maximize his total utility, will make his first purchase where his marginal util-per dollar spent is the greatest. Column 4 shows the marginal utility per dollar spent on the first is 8 utils per dollar, whereas in column 8 the mar-udlit) per dollar spent on the first beer is 10 udls dollar. Fred will dierefore first purchase a beer at leaving him $9. Now a second beer gives him 8 utils r dollar, the same as for the first pizza; he will there-be indifferent between die two choices. Ifhe fust s a pizza; he will next buy a beer (why?), ernauvely, if he first buys another beer, he will next a pizza (why?). Either way, $6 of income remains, usc the marginal utilit) per dollar spent is now ter for beer than for pizza, (7 vs. 6), he will next a beer. This will be followed by a pizza (6 vs. 4). $3 is left and again he is indifferent between the

two choices since they both yield 4 udls per dollar. Thus, with his last $3 he will buy one more beer and one more pizza for a total of three pizzas and four beers. His $10 income will yield a total of 65 udls, 36 from pizza and 29 from been We challenge you to fmd any alternadve combinadon which Fred can buy with $10 that will give him greater total udlity. The reason that you cannot is that

pizza

pizza

beer

is a condition for a utility maximum. When the marginal utility per dollar spent is the same for all goods purchased (or as close as possible), total udlity has been maximized.

Moreover, precisely the same result would have been obtained wherever Fred begins. Suppose instead that he is currendy spending his endre $10 income on pizza, enabling him to purchase cxacdy five pizzas for a total udlity of 49. Buying one pizza less, however, enables him to buy two additional beers. In so doing, the loss in udlity from consuming one less pizza, 6 utils, is more than offset by the gain in udlity from consuming the fust two beers, 18 utils (10 + 8). Hence he would gain twelve more udls (18 - 6) by subsdtudng 2

Table V Maximazing Freds Utility on a $10.00 Income When Pps$2.00 & Pk = $1.ffi)

Consumed

© 4

(5) Beer Consumed

Pizu: Tolal Utility

Maralul

4) Pna: Marginal UUIity per dollar

(6) Beer: Total Utility

Beer: MaroiRal Utility

Marginal Ulillty Mr dollar

=-10

=- 7

=- 4

=- 3



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