Does consumer surplus over-weigh the interests of high-income consumers?

Question

An individual's willingness to pay for a good not only depends on how much they value that good, but also on their income level (at least under the conventional non-economics definition of the word 'value').

Consider the case with a single indivisible unit of a good and 2 consumers, a very wealthy consumer and a very poor consumer. Even if the poor consumer would benefit more from receiving the good than the wealthy consumer (let's say the good is a drug that the poor consumer medically needs but the rich consumer wants to take recreationally), the 'efficiency-maximizing' free market will still give the good to the wealthy consumer under most conditions. The wealthier consumer has a higher willingness-to-pay not because the good is worth more to them, but because a single dollar of their wealth is worth less.

The normative idea that a good should always go to the individual with the highest willingness to pay is then surely flawed. The policy objective of maximizing surplus, which follows from this idea, must also be flawed. Given how glaring this problem is, I am surprised to see so many papers that still use WTP-derived consumer surplus in their normative analysis.

My questions are:

-What does the literature have to say about this issue?

-Have alternative measures of surplus been proposed?

-Is my reasoning flawed/is the measure of CS not as unfair as I am suggesting?

Partly inspired by some of the arguments in this thread: What does economics say about "price gouging" during an emergency?

Answer 1

Consumer surplus in Microeconomics 101 is indeed often used in the way you describe and to illustrate a point about the allocation efficiency of a free market.

However, it is important to keep in mind the assumptions and limitations of the framework you describe.

First, the case you describe is a partial equilibrium case. This framework does not allow for such general statements as you are making about all goods always going to richer people. In partial equilibrium we look at one small market and forget about everything else. To use such a framework we must accept that it is reasonable for our question at hand to analyze one purchase in isolation. That assumption is clearly not reasonable for the question you have on all goods and as such the framework you describe cannot be used as it will lead to false conclusions.

With partial equilibrium we can look at this purchase in isolation from other markets. If income effects and the purchases in question are important then we cannot use the consumer surplus idea as done in Micro 101. Certainly this is an issue for the point you raise about all goods always going to a wealthier consumer. All goods cannot be analyzed with partial equilibrium.

The good allocation properties that economist often talk and that you mention about are based on general equilibrium and the proofs do not really involve the concept of consumer surplus.

To fully ensure avoidance of income issues, we often work with quasilinear utility functions when talking about consumer surplus and allocation, as you are doing. It is important, however, to keep in mind that these utility functions are special cases. They imply that income effects do not matter so they are widely used in Micro 101 for illustrative purposes.

Consumer surplus has a nice interpretation for quasilinear utility functions: it’s equal to the gain in utility. This makes quasilinear utility functions especially instructive. If everyone’s utility function has this form then the Pareto efficient allocations are exactly the allocations that maximize total consumer surplus (in the absence of production).

So when using consumer surplus to talk about efficient allocation you need to accept the assumptions that go along with quasilinear utility. However, such utility function are only realistic for certain goods and certainly not for all goods.

Luckily, what you learned about free markets achieving allocation efficiency is still true even when considering more complex cases. However, these results are then true for different reasons and under different assumptions than what is taught through consumer surplus in introductory lessons.

Answer 2

First, in all the equilibrium analyses, you should consider both consumers and producers (There are special cases like pure exchange economy, which is simplified to illustrate some points). So normally, the policy objective is not to maximize consumer surplus only but to maximize consumer surplus plus producer surplus.

Second, the equilibria described in Micro are usually specified by a price vector, a production vector, a consumption vector, and a transfer (equivalent as a wealth redistribution/assignment/allocation). The transfer here is specifically important to your questions. With a proper transfer among the rich, the poor, and the producer (of the drug), the problem can be solved together with the assumptions in the (price, Walrasian) competitive equilibrium.

As you have said that Pareto optimal is actually the minimum requirement for an equilibrium outcome. An economy can have extremely high inequality among people while still be Pareto optimal. The Second Theorem of Welfare Economics solves this problem by proving that any Pareto optimal outcome can be achieved by a price equilibrium with transfers. (The Frist Theorem says that every equilibrium is Pareto optimal just for your reference.) However, there are several problems with this theorem.

At that time, the assumptions used in achieving this result were considered mild and reasonable. However, the assumption about complete information seems to be very unrealistic right now. Incomplete information, as well as asymmetric information, is present in every corner of the economy. There are so many to say on this issue.

Also, the assumption of a competitive market is also unrealistic. Oligopoly is everywhere in the economy. As the example you mentioned, the pharmacy industry is definitely going to be an oligopoly market. In order to extract the most profit from the economy, they won't choose the production bundle that is best for all the people in the economy, so there will definitely be a shortage of new drugs.

Back to your question, first, it is not even a pure exchange economy in your example, and you miss the role of producers. The policy objective is not to maximize consumer surplus only. Second, under a set of assumptions, a proper transfer together with a proper price vector, a proper production bundle, would constitute the desired Pareto optimal outcome. However, how to get to that place? How to eliminate monopolistic market power while making the firms have enough incentive to innovate at the same time? Those are tough questions, and the role of information is also important in answering those questions.