No Such Thing as a Free Lunch: Principles of Economics (Part 28)

War used to be something you could stand on the nearby hill and watch. Now we have total war; everybody's in it. We have total economics as well. Everything affects everybody. The Malaysian currency shakes, and people around the world are seriously affected.

Salmon Rushdie

Household Behavior and Consumer Choice

(Part D)

by

Charles Lamson

Consumer Surplus

As we have seen, the market forces households to reveal their preferences. The true cost of an item is the value of the other things that you give up when you buy it. The true cost is the opportunity cost. 

In Part 19 of this analysis the notion of consumer surplus was introduced. In competitive markets, each good sells for a single market price, and consumers can buy all they want and can afford of each good at its market price. For many, the amount that they are willing to pay for a good is greater than what they must pay for it. To the extent that a household's willingness to pay for a good exceeds the good's market price, the household earns a surplus, called consumer surplus. As was showed in Figure 6 from Part 19 and reintroduced below, the total consumer surplus enjoyed by households in a given market is equal to the area under the demand curve above the equilibrium price (where the supply of goods matches demand). 

The idea of consumer surplus helps to explain an old paradox that dates back to Plato. Adam Smith wrote about it in 1776:

The things which have the greatest value and use have frequently little or no value in exchange; and on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarce anything; scarce anything can be had in exchange for it. A diamond, on the contrary, has scarce any value and use; but a very great quantity of other goods may frequently be had in exchange for it.

Although diamonds have arguably more than " scarce any value in use" today (e.g., they are used to cut glass), Smith's diamond/water paradox is still instructive, at least where water is concerned. 

The low price of water owes much to the fact that it is in plentiful supply. Even at a price of 0 we do not consume an infinite amount of water. We consume up to the point where marginal utility (Again, note that in economics, utility is the benefit or satisfaction derived by consuming a product, thus the marginal utility of a good or service is the change in the utility from an increase in the consumption of that good or service.) drops to zero. The marginal value of water is 0. Each of us enjoys an enormous consumer surplus when we consume nearly free water. We tend to take water for granted too, but imagine what would happen to its price if there were simply not enough for everyone. It would command a high price indeed. 

Consumer surplus measurement is a key element in cost-benefit analysis, the formal technique by which the benefits of a public project are weighed against its costs. To decide whether to build a new electrical power plant, we need to know the value, to consumers, of the electricity that it will produce. Just as the value of water to consumers is not just its price times the quantity that people consume, the value of electricity generated is not just the price of electricity times the quantity the new plant will produce. The total of value that should be weighed against the costs of the plant includes the consumer surplus that electricity users will enjoy if the plant is built. 

*MAIN SOURCE: CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 114-115*

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