Clarification on Consumer Surplus
By David Henderson
Commenters on my previous post on consumer surplus (CS) raised some questions that I want to respond to.
1. Philo points out that in figuring out our consumer surplus, our baseline matters crucially. So, for example, my CS from one package of Advil, given that I can buy another only an inch away for the exact same price, is zero, even if the Advil instantly cures a splitting headache. But my CS from that Advil, if my baseline is having no other Advil and no other pain relief medicines, could be very large indeed.
This matters for companies pricing their products. One of my longest-time friends has made a really good living helping firms price their products. He has pointed out to me that often the other consultants and company decision-makers he consults to make an elementary mistake by not understanding the issue of the baseline. They will see what a great product they have and then shoot for the moon by wanting to charge a high price that captures much of that large CS. The problem: if there’s another company with a product that’s almost as good, that apparently large CS is not so large and the price premium they can charge is roughly equal to the difference in the consumer’s valuation of the two products.
2. Philo also points out that when a product is given away, there is no trade. He’s right. I should have stated that CS is almost always a measure of the consumer’s gain from trade. When the product is given away, though, there is no trade but there is still CS.
3. Robert Johnson, after complimenting me on the post (thanks, Robert), raises an interesting question:
If I’m starving, then I might be willing to spend everything I have for a loaf of bread. But if everything I have is one dollar, and the bread costs $2, then it’s definitely the wrong conclusion to say that my consumer surplus from buying the bread is minus one dollar. If the bread costs $1 then it’s still the wrong conclusion to say that my consumer surplus from buying the bread is $0.
Suggestions for how to solve this problem?
Here’s my answer. First, if all you have is $1 and the bread is priced at $2, then you don’t have negative CS because you don’t buy the bread. (I’m assuming away the possibility of borrowing to buy the bread.)
Second, if you have $1 and the bread is priced at $1, and you buy it, your CS really is zero. How do we know? Because if it had been priced at $1.01, you wouldn’t have bought it.
This gets to the issue of “willingness to pay.” We economists use that term very differently from how almost everyone else uses it. By “willing to pay,” we mean what other people mean when they say “willing and able to pay.” So, for example, if someone says, “I’m willing to pay $10 but I have only $1,” then (again, assuming no possibility of debt), the economist will respond, “No, you’re not willing to pay $10.” I think non-economists sometimes think we’re being smart asses or, even worse, callous people, when we say that, but I don’t think we are. We’re just sticking with this peculiar use of language.