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2.2 FUNDAMENTALS OF MARKETS 15
For most, if not all, practical commodities, the demand function is downward sloping,
that is, the amount consumed decreases as the price increases. The inverse demand
function has an important economic interpretation. For a given consumption level, it
measures how much money the consumers would be willing to pay to have a small
additional amount of the good considered. Turning this around, it also tells how much
money these same consumers would want to receive in compensation for a reduced
consumption. Not spending this amount of money on this commodity would allow
them to purchase more of another commodity or save it for purchasing something at a
later date. In other words, the demand curve gives the marginal value that consumers
attach to the commodity. The typical downward-sloping shape of the curve indicates
that consumers are usually willing to pay more for additional quantities of a commodity
when they have only a small amount of this commodity. Their marginal willingness
to pay for this commodity decreases as their consumption increases.
The concepts of gross and net consumer’s surplus that we defined above for a single
consumer can be extended to the gross and net surpluses of a group of consumers. As
Figure 2.5 illustrates, the gross surplus is represented graphically by the area below the
inverse demand function up to the quantity that the consumers purchase at the current
market price. The net surplus corresponds to the area between the inverse demand
function and the horizontal line at the market price.
The concept of net surplus is much more important than the calculation of an
absolute value for this quantity. Calculating the absolute value of the net surplus is
quite difficult because the inverse demand function is not known accurately.
Examining how this net surplus varies with the market price is much more interesting.
Figure 2.6 illustrates the change in net surplus when the market price increases.
If the market price is π1, the consumers purchase a quantity q1 and, the net surplus is
equal to the shaded area. If the price increases to π2, the consumption level decreases
to q2, and the consumers’ net surplus is reduced to the roughly triangular area labeled
A. Two effects contribute to this reduction in net surplus. First, because the price
is higher, consumption decreases from q1 to q2. This loss of net surplus is equal to
the area labeled C. Second, because consumers have to pay a higher price for the
Price
Gross consumers'
surplus
Market price
Price
Net consumers ,
surplus
Quantity
Quantity
Figure 2.5 Gross consumers’ surplus and net consumers’ surplus