37487 No. 5 KNOWLEDGE EXCHANGE Series May 2006 A Primer on Consumer Surplus and Demand: Common Questions and Answers by Henry M. Peskin Measuring consumer's surplus is an increasingly popularapproachtoquantifyingthemonetarybenefits of energy projects at the World Bank. This note provides a brief primer on the concept and addresses some concerns and criticisms for this method. Introduction Consumer's surplus--a measure of well-being that relies on the difference between what a person, household, or group is willing to pay for energy and what actually has to be paid-- has a long history in economics as a method for estimating the benefits of public projects (Marshall, 1930; Varian, 1978). The first use of applying consumer's surplus for valuing the benefits of electricity in the World Bank was seen as early as 1975 (Anderson, 1975). This was followed by a more elaborate exploration of the concept in the mid-eighties (Pearce and Web, 1985). Recently, the increasingly popular approach The demand curve shows the relationship between the price is applied in almost all rural electrification projects, including facing the consumer and the quantity consumed at that price. in countries such as Bolivia, Lao PDR, Peru, and Philippines Of course, the quantity of energy consumed at any point in (O'Sullivan and Barnes, 2006). The procedure, although fairly time depends on far more than its price--the weather, the easy to apply, is not always well understood and is not without taste for energy-consuming items such as radio and TV, the its critics, even by those educated in its underlying principles. need to support energy needs of business, and most importantly, the consumer's income. Clearly, if one chooses This paper provides a brief primer on the concept and ad- to focus just on the relationship between energy prices and dresses some of the more frequent criticisms that emerge when energy consumed, these other factors must somehow be held applying this method. One criticism not addressed is that "constant." In general, if all the non-price factors remain fixed, money and well-being are not necessarily the same thing and the higher the price of a good (in this case energy), the less therefore questions whether any monetary measure of benefit likely the consumer will demand it. is valid. This criticism is the subject of a companion paper currently in preparation on benefit estimation (see Box 1). The demand curve shows price-quantity relationship for an individual, a household, a group of individuals, or a group of Consumer Demand households. The interpretation of the curve differs if it shows The starting point for an understanding of consumer's surplus an individual or a group, especially if the group contains a is the consumer demand curve shown in Figure 1: mix of incomes and tastes. Figure 1: Demand Curve For a heterogeneous group, the tendency for higher prices Price leading to lower energy consumption usually implies that most of the consumption at high prices is by those individuals with P0 Demand Curve ESMAP is a multi-donor trust fund managed by the World Bank Energy and Water Department (EWD) that promotes the role of energy in poverty reduction and economic growth in an environ- mentally responsible manner. Its work applies to low-income, emerging and transition economies and contributes to the achievement of internationally agreed development goals. Q0 Quantity ESMAP Knowledge Exchange Series No. 5 1 KNOWLEDGE EXCHANGE Series May 2006 higher incomes or with a stronger desire for energy. For an Estimating the Demand Curve individual, the lower consumption at higher prices usually means that the individual will tend to substitute for other goods Consumer's surplus greatly depends on the shape of the that provide a less costly means to maximize his or her demand curve, particularly between the original Q0, P0 satisfaction or well-being. In either case, if the market price combination and the new Q1,P1 combination. If the curve of energy is below what some people would be willing to pay were not a simple straight line but instead bowed or bent for it, these people would experience a gain in their well- towards the origin of the graph such as indicated by the being. This gain is the principal argument for using consumer's dotted line, the consumer's surplus would be smaller, as surplus as a benefit measure. shown by the more lightly shaded area. Although the consumer's surplus could be far smaller than that measured Consumer's surplus can be illustrated in the following in the World Bank's ESMAP energy studies, the investigators diagram: chose not to assume that it is smaller (World Bank, 2002). Figure 2: Demand Curve showing Consumer's Surplus Instead, the studies based the demand curve (and the resulting measure of consumer's surplus) on actual price- a quantity observations drawn from household surveys. For P0 combinations not observed, there was a simple linear Demand Curve P* extrapolation between points that were observed. Of course, the extrapolated points may not fall on the "true" (but b c unobservable) demand curve. P1 However, since the extrapolations rely solely on what can Q0 Q* Q1 be observed, the investigators feel that this is a more honest approach than simply assuming some sort of curvature If the price of energy fell from P0 to P1, those individuals (or a between the observable points. Such assumptions are particular individual) who would be willing to pay P0 in order necessarily arbitrary and could produce a wide range of to consume Q0 of energy, can now consume the Q1 of results. Besides the problem of estimating the "correct" energy at the lower price. The original "Q0-consumers" (or in demand curve, the application of the consumer's surplus the case of an individual, the "Q0 consumption") realize a method has raised a number of questions and criticisms "benefit" of P0 ­ P1 for each of the units of Q0 consumed. addressed below. This benefit would be realized for any consumption less than Q1 corresponding to any price higher than P1, such as for Are two points adequate for estimating the demand those willing to pay P* for Q* units of energy. Thus, when one curve? considers all consumption-price combinations between the original Q0, P0 combination and the new Q1, P1 combina- Of course, if only two points are observed, the estimated tions, the total of all gains is represented by the shaded demand curve will necessarily be a straight line, as in the triangle a,b,c plus the rectangular area P1, P0, a, b. above diagrams. If it is somehow known that the "real" demand curve has more curvature, then a two-point esti- In brief, energy is demanded for the service that it provides. mate is certainly not adequate. However, estimating more Therefore, to calculate consumer's surplus requires an curvature requires more observation. estimate of demand for lighting, entertainment, communications, or other services closely linked to energy. Fortunately, for those studies where data permitted For lighting, the demand is quantified as kilo-lumen hours estimation of some curvature, the difference between the and for entertainment, it is radio or television listening or straight line consumer's surplus and the more correct (and viewing hours. Thus, it is possible to obtain a measure of lower) value obtained with a more curved demand curve consumer's surplus by using the price and quantity of kilo- was fairly small (Barnes, Fizgerald and Peskin, 2002). The lumen or radio listening hours for households using kerosene, qualitative conclusions of the studies were not changed. batteries or electricity from a grid system (World Bank, 2002). While this fortunate outcome cannot be guaranteed in all This note assumes that the benefit measured by consumer's future energy studies, a large gain in consumer's surplus-- surplus is a satisfactory measure of the benefit of policy that regardless of the shape of the demand curve--is an brings about lower energy prices and considers key challenges expected outcome of the large fall in energy costs due to in this approach. electrification. ESMAP Knowledge Exchange Series No. 5 2 Whose demand curve is it anyway? Box 1: What Does it Mean to Measure Project Benefits? These studies have chosen to estimate the demand curve for Benefit or well-being is essentially a psychological concept that groups of similar households--similar with respect to their depends on physical factors facing the household such as the tastes for energy and their abilities to pay for energy. level of wealth, amount of consumption, or the state of the environment. While the costs or prices of such factors may Because it would be impossible to group households by all affect their physical levels, these costs or prices should not the factors that could affect energy demand, the households directly affect the well-being of a rational household. If one were grouped by income class (and in some studies, also by household paid $30 thousand for an automobile, while another household paid $50 thousand for the same automobile, under location). Certainly, not every household within an income assumptions of rationality, the second household would not be class is just like every other household in that class. For some considered better or worse off (everything else being equal). prices, certain households may consume somewhat more Thus, the heavy dependence of consumer's surplus on prices is or somewhat less. The expectation is that within the income considered a deficiency of consumer's surplus as a measure of benefits. (This deficiency is a form of what economists refer to as class for any observed price, the consumption is on average money illusion.) "correct." Fortunately, consumer's surplus is a good approximation to two accepted benefit measures that do not share this defect (but Does willingness-to-pay overestimate ability-to-pay? which are harder to estimate): the equivalent variation measure and the compensating variation measure. These measures Some critics of the consumer's surplus--with its reliance on monetize the physical factors by assigning prices: original or "base" prices for the former and post-policy prices for the latter. the difference between the "willingness-to-pay" price and In fact, consumer's surplus lies between the two. the market price--argue that the willingness to pay may be higher than the household's ability to pay. An underlying assumption behind this criticism is that a household's low income may make it impossible to pay as much as it may households are willing to pay for those energy desire. It should be kept in mind, however, that the demand services that apparently are highly valued--in particular, curves in the ESMAP studies cited above are based on lighting.For example, according to a study in the Philippines observations of what is actually paid for a given amount of of rural electrification, the non-electrified household is likely energy consumption. In principle, therefore, there is no to spend per kilo-lumen hour 48 times more than the difference in these studies between the "willingness-to-pay" electrified household. If the average rural household can get price and the "ability-to-pay" price. It is true that because their lighting at the lower price through electrification, their households within the groupings may not be exactly the same, monthly demand for lighting increases by a factor of 50. Of certain households in the group may not be able to afford course, these estimates could be much different for those certain consumption levels depicted by the demand curve. countries far poorer than the Philippines. Nevertheless, the Or on the other hand, other households in the group may combination of a high willingness-to-pay for a small quantity be able to afford somewhat more energy than depicted by of energy with a huge increase in demand with lower energy the demand curve. With a large enough household survey, prices easily explains the high consumer's surplus estimates. the observed actual payment-quantity consumption levels should be, on average, correct for all households in the Aren't the estimates affected by subsidies and taxation? group. Since the demand curves are based on actual behavior, they Why is consumer's surplus so large? reflect any subsidies or taxes that affect the energy prices facing the household. For example, the very high "price" of The consumer's surplus lighting with kerosene is even higher where kerosene is heavily estimates in all of the energy taxed and the very low price of electricity facing the house- studies completed so far at hold is even lower where electricity subsidies are large. Both the World Bank have been effects tend to increase consumer's surplus. Indeed, as the quite large--even where the companion paper on benefit estimation argues, this high data allowed for demand sensitivity to price changes is one defect in using consumer's curve estimates with surplus as a measure of electrification benefit. (See Box 1.) "curved" shapes. Moreover, A more important problem is that a consumer's surplus the estimates have been measurement of electrification benefit is often very partial: it large even for the least wealthy income classes. This result looks at electricity demand and not elsewhere in the economy. is not surprising when one realizes how much even the poorest Subsidies, for example, could have a short-run effect of ESMAP Knowledge Exchange Series No. 5 3 increasing household consumer's surplus but a longer-run Quantitative preferences (monetary measures that can be effect of decreasing household benefit if the costs of the compared across programs and to quantitative costs) are subsidy eventually fall on the household in the form of higher necessary to make choices between many desirable projects. household taxes or a decrease in governmental services. Quantitative benefit estimates thus assist in the selection of these Consumer's surplus estimates (or any other benefit estimate for programs. Quantitative benefit estimates can also assist in the that matter) may not tell the whole story. They may reflect the management of programs as well. For example, the apparent short-run benefits of energy policy on lower energy costs facing very high consumer's surplus estimates associated with the household but ignore longer-run effects on well-being from, electrification suggest that the need for subsidization may be for example, decreased medical care due to shifts from health far less than is currently believed necessary. programs to energy programs. Such adverse longer-run outcomes are hardly inevitable but suggest the need for a Consumer's surplus estimation is an important and practical holistic approach to all policy making. method of developing such quantitative estimates of benefits. The increasing popularity of this approach at the World Bank is Why not simply ask consumers about their benefits from well justified. electrification? There are several methods of measuring electrification benefit References other than by estimating consumer's surplus. Indeed, some of these methods have to be used in the absence of data Anderson, Dennis. 1975. Cost and Benefits of Rural Electrification: A Case Study of Costa Rica. World Bank Public Utilities Report No. RES 5. World permitting estimation of a demand curve. If there is only interest Bank, Washington, DC. in determining the qualitative benefits of electrification, direct Barnes, Douglas F., Kevin Fitzgerald, and Henry M. Peskin. 2002. The Benefits questioning of electricity users and potential users may be more of Rural Electrification in India: Implications for Education, than adequate. These direct surveys have indicated a very strong, Household Lighting, and Irrigation. World Bank, Washington, DC. qualitative desire for electrification. However, surveys of other Freeman, A. Myrick, III. 1993. The Measurement of Environmental and possible public services, such as health or education, also Resource Values. Resources for the Future, Washington, D.C. indicate strong desire for these programs as well. Marshall, Alfred. 1930. Principles of Economics. Eighth Edition. MacMillan and Co, London. Some economists have used survey methods of determining quantitative estimates of benefit and a few of these have been O'Sullivan, Kyran and Douglas F. Barnes. 2006. Energy Policies and Multitopic Household Surveys: Guidelines for Questionnaire Design in Living used to assess World Bank programs as well. These methods Standards Measurement Study. Paper No. 17. World Bank, are known as contingent valuation surveys. Unfortunately, they Washington DC. are difficult to apply because they require very carefully worded Pearce David and Michael Webb. 1985. Economic Benefits of Electricity Supply. questions in order to ensure that the respondent will Energy Department Paper No. 25. World Bank, Washington D.C. answer truthfully. Therefore, even where successful, contingent Varian, Hal R. 1978. Microeconomic Analysis. Third Edition. W.W. Norton and valuation surveys are usually very expensive. For these reasons, Co, New York. this approach is controversial among economists. World Bank. 2002. Rural Electrification in the Philippines: Measuring the Social and Economic Benefits. ESMAP Report 255/02. Washington, DC. Conclusion Policy choice requires more than expressions of qualitative preferences of what is or is not desirable or beneficial. Copyright 2006 Photo Credits: © Douglas F. Barnes Production Team: Marjorie K. Araya, Douglas F. Barnes, and Samantha M. Constant Henry M. Peskin is President of EdgevaleAssociates and a consultant to the World Bank. The findings, interpretations, and conclusions expressed in this paper are entirely those of the author (s) and should not be attributed in any manner to the World Bank, or its affiliated organizations. 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