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Theoretical and Practical Importance of Consumer’s Surplus

Updated on June 12, 2014

Introduction

We can certainly conclude that the method of measuring consumer’s surplus is purely hypothetical. However, the consumer’s surplus theory has significant theoretical and practical importance. According to Prof. Thomas, “Consumer’s surplus seems concrete enough, in fact, we can see it in everyday world, though the method of measuring it is purely hypothetical.”

Theoretical Importance of Consumer's Surplus

Value-in-Use and Value-in-Exchange

Value-in-use refers to utility derived from a particular commodity. Value-in-exchange refers to price of a commodity. Theories attributed before consumer’s surplus claimed that price of a commodity indicates its usefulness. However, this is not true in real life situation. For instance, commodities such as water and salt possess higher value-in-use but less value-in-exchange. Therefore, we cannot claim that price of a commodity indicates its usefulness. The concept of consumer’s surplus is very helpful to understand this scenario. The theory of consumer’s surplus clearly shows the difference between value-in-use and value-in-exchange.

Fair Tax Policy

The basic principle of taxation is that taxes should give maximum revenue to the government without affecting the welfare of the people. This is known as fair tax policy. However, determining a fair tax is tedious and confusing. The concept of consumer’s surplus is helpful to determine a fair tax. Marshall explains that both imposing new taxes and granting subsidies tend to affect consumer’s surplus in a considerable manner. He further provides the policy makers with a solution to this problem i.e., the government should impose taxes on increasing cost industries and provide subsidies to decreasing cost industries.

Direct Taxes versus Indirect Taxes

Which one is better – direct tax or indirect tax? It has always been the cause of disagreement among policy makers. However, the theory of consumer’s surplus clearly favors the system of direct taxation because while imposing indirect taxes, the whole burden is passed on to the community. Therefore, indirect taxes tend to affect the welfare of the people.

Practical Importance of Consumer's Surplus

Dupit-Hottelling Theorem

Dupit-Hottelling theorem claims that a monopolist makes necessary adjustments to his prices in order to secure maximum profits or increase sales. Note that this activity of a monopolist directly affects the consumer’s surplus. If a monopolist is afraid of competition, he slightly reduces the price of his commodity. The reduction in the price provides consumer’s surplus. Therefore, sales increase. On the other hand, if the monopolist is not necessary to fear about competition, government intervention or an objection from consumers, he will be able to raise the price of his commodity. A raise in the price may completely alleviate consumer’s surplus. Hence, we can understand that everything revolves around the doctrine of consumer’s surplus in all real life situations.

Better Economic Index

The doctrine of consumer’s surplus serves as better economic index. If the consumer’s surplus is high, it implies that the economy is in the growing phase. The reason is that the seller allows consumer’s surplus when he starts facing competition; healthy competition implies industrial development. If the consumer’s surplus does not prevail in an economy, it implies that the economy is in tough situation. Therefore, the concept of consumer’s surplus is an economic indicator that shows the development of an economy at different stages and at different periods.

Spiritual Father of Welfare Economics

Economists consider the concept of consumer’s surplus as the “spiritual father” of welfare economics. The doctrine of consumer’s surplus is very closely associated with the welfare of a society. If the consumer’s surplus is high, people will be better off because of the surplus money in their hands. On the other hand, if the consumer’s surplus is low or zero, it implies that there is an adverse impact on the society because of high prices.

International Trade

The concept of consumer’s surplus is very helpful in the field of international trade as well. According to Marshall, to gain maximum benefit from an international trade, the country should carry out the trade in such a way that its residents get maximum consumer’s surplus. What do we need to do to perform such trades? Heckscher-Ohlin theory of international trade provides us with the solution. A country should import those goods whose cost of production is high and should export those goods whose cost of production is low.

Decision-making

Cost-benefit analysis is an eminent tool in economics in the area of decision-making. Cost-benefit analysis is carried out while investing on construction of bridges, railways, dams, parks and so on. The concept of consumer’s surplus is an essential tool in cost-benefit analysis. Expected consumer’s surplus is calculated before taking decisions on such big constructions and investments.

© 2013 Sundaram Ponnusamy

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