BUYING JEANS: A CONSUMER SURPLUS PARABLE

Say you’ve come down from the office to go out for lunch. Out in the street you see a clothing pop-up store with nice jeans at $100 a pair. You have a quick look thinking that you do need a new pair of jeans but, at $100, they’re a bit expensive. On your way back from lunch you see the pop-up store is closing down for the day and the jeans you like have been marked down to $50. You go and buy a pair. From this observed behaviour we can conclude that your subjective, personal, internal valuation of those jeans is somewhere between $100 and $50 – we don’t know exactly what it is, but we know it’s somewhere in that range. Let’s assume that your internal valuation is $75. That explains why you wouldn’t buy at $100 but would buy at $50. So, by buying the jeans you have made yourself $25 better off, that is, the $75 better off you are now because you own those jeans minus the $50 you had to pay to get them. This $25 is like a kind of ‘personal profit’ that you make from the purchase. It’s actually why you make the purchase. Economists call this personal profit, consumer surplus. Consumer surplus, or at least the expectation of it, is what drives all transactions everywhere. It is by the creation of consumer surplus that markets create value and benefits for society.

We can extend this idea of consumer surplus from the individual to an entire market. Imagine we had some alien tech way of knowing the internal subjective evaluation of everybody who bought jeans in a particular city on a particular day – some kind of valuation mind-reading device. And assume also that we know the price that everyone paid and the number of jeans that were sold. Now we can work out the total consumer surplus for everybody who bought jeans on that day – or total market consumer surplus. Now we can say how much better off society was made on that day because of the existence of a market for jeans.

Note that we don’t need the alien tech mind scanning device to enable markets to work their magic – markets achieve the creation of consumer surplus value simply through the many interactions of individual buyers and sellers in the marketplace.

This is how markets make society better off. I’ll just note in passing that there is a boatload of assumptions behind this little story, but it serves to illustrate the point.

Notice one more thing: the price of something is what someone is willing to pay for it. What a market does is find that price. This price is one measure of value. The idea of consumer surplus is another and complementary idea of value.

The critical thing is, when a market is operating well (and we don’t have time to talk about what that means even though it’s very important) it generates prices. We don’t need to come up with a valuation method when markets are operating precisely because a market is a valuation method. But when we don’t use markets and governments provide goods or services we need other methods to determine what they are worth to society.

Finally, value is a multi-dimensional and subjective concept. The starting question is: ‘value to whom?’ The answer to what is value depends, among other things, on whether we’re talking about an individual, a family, a region, a state and country or the planet in relation to their respective populations.

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