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Consumer Surplus and Related Absurdities

By James H. Nolt

A few weeks ago I left off my series criticizing the way economics is taught in order to discuss critical economic events, but this week I pick up the thread last visited in my blog “Private Power and Price Stability.” In that article, I argued that private regulatory powers, more than governments, are the political force that stabilizes prices under capitalism, though those private powers are of course exercised for private rather than public benefit.

Economists do pretend to measure public benefit using a method of calculating “consumer surplus” and its mirror, “producer surplus.” Virtually the entire enterprise of formal public policy analysis, taught at scores of leading universities, spawning a consulting industry in the billions of dollars, is founded on this most dubious tool in the economists’ toolkit. This has become such a bedrock idea in economics that many introductory textbooks now teach it even before they teach about production and the theory of the private enterprise firm (which, by the way, is where classical political economists like John Stuart Mill start).

Consumer surplus is based on the supply and demand equilibrium that I questioned in the previous blog cited above. Supply and demand intersect in an ‘X’ graph, with the X-axis (horizontal dimension) measuring the quantity of whatever good under consideration being supplied or demanded and the Y-axis (vertical dimension) measuring the price of that good. The supply curve rises from left to right, reflecting the idea that producers will be willing to supply more of a good as its price rises. The demand curve falls from left to right, illustrating the Law of Demand, i.e., that consumers will buy more of anything as its price falls. The intersection of the two marks off the equilibrium price and the quantity that will be sold and bought at that price, assuming free markets.

The roughly triangular area above the equilibrium “free market” price and below the demand curve is called the consumer surplus. The producer surplus is under it, between the supply curve and the equilibrium price. These two areas have a very special, indeed enormous, role in public policy analysis. Public cost-benefit analysis, whether of the effect of a tax, environmental regulation, or new bridge, can be incorporated into the appropriate supply and demand curves and then the public cost or benefit estimated. As I said, this is treated as high science and is the basis of much so-called “expert” opinion on public policy issues.

Look into the details and the whole procedure is laughably bogus. What does “consumer surplus” actually mean? It is a quantum of happiness enjoyed by all those consumers (presumably the richer ones) who were willing to pay more for a product, reflected in the ascending portion of the demand curve, but were not required to pay as much as they were willing to because the free market so efficiently delivered the product to them at the free market equilibrium price, which is below the “reservation price” they would have been willing to pay. It’s as if the rich delight it not being price gouged.

If all this counterfactual argument is making you dizzy, let’s try a practical example. Imagine Bill Gates, usually considered the richest man in the world, has a hankering for a pizza. Since his net worth is in the tens of billions of dollars, he would be willing to pay, oh I don’t know, say $10,000 for his pizza. He really wants it, and $10,000 is nothing to him. But it turns out the free market will deliver a pizza to him, given the Law of One Price, at exactly the same $10 price that everyone else pays. The $9,990 difference is his consumer surplus! But this is not money added to his wealth, this is, remember, a measure of utility, or, in common terms, happiness. Bill Gates has enormous quantities of happiness measured in surplus dollars not needed to pay for things he would be willing to pay more for!

This entire exercise is utter nonsense as soon as you start looking into the details. First of all, economic utility theory since its inception in the eighteenth century has always argued that units of money have diminishing marginal utility. In other words, one extra dollar of income to Bill Gates is worth far less in happiness than one extra dollar to a homeless beggar. That is just common sense.

And yet, when it comes to measuring “consumer surplus,” since the happiness of individuals is seemingly hard to quantify, economics takes an “innocent” methodological shortcut and measures consumer surplus not in units of happiness, such as “utils,” but in units of money, such as dollars. These are summed across all individuals in society as if a dollar’s worth of happiness gained by one individual is exactly equivalent to a dollar lost by another. But that methodology violates the fundamental tenant of economists’ own belief system: the idea that dollars have diminishing marginal utility as you gain wealth.

The consumer surplus method requires assuming that total social welfare is the same if Bill Gates gains one more dollar at the expense of a dollar lost by a hungry homeless veteran. Measuring social happiness (or “welfare”) that way, it is necessarily true that all of the billions spent on cost-benefit analysis for the supposed scientific allocation of resources in fact systematically biases every public decision in favor of the rich. And economists call this “positive economics,” devoid of moral content!

It is certainly devoid of conscience.

It gets even more bizarre than that. Remember, consumer surplus is measured for each of millions of products based on willingness to pay, so if you add up all the myriad of things that rich people might be willing to pay more for but don’t, then collectively they must be ecstatically happy enjoying this enormous bounty of consumer surplus! Well maybe they are. Though in fact, psychologists’ studies of happiness generally show that above a middle class level of income, there is no significant gain in happiness with higher incomes. The poorest are certainly less happy, but the richest are not noticeably happier than the middle class.

That empirical finding, by the way, invalidates the entire psychological conceit of consumer surplus theory. It shows how ludicrous are the pretentions of thousands of experts who claim authority based on scientific and analytical studies of public policy concerns. It is about time for people to pay attention to how decisions are being made in their name and restore some common sense to public policy!

Next week I will explore how the vastly higher incomes of the rich do distort economies. It is not by causing the price of pizzas to rise to what Bill Gates could afford to pay, but concentrated wealth does tend to bid up the value of scarce resources that cannot be produced the way pizzas can, i.e., land and natural resources. These become more and more expensive, particularly the most desirable parcels, as the wealth of the rich allows them to bid up land prices to levels that allow them to exclude most others from locations they prefer. This fact also has profound implications for the business cycle and the instability of the financial system.

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James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University. 

[Photo courtesy of Wikimedia Commons]

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