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Measuring Economic Value

October 20, 2011

Prerequisite: Action and Choice.

What is something worth? Can we determine objective value from any observable facts? The most commonly used economic statistic about aggregate value, GDP, measures P x Q, where P is the price of a good and Q is the number of goods. We know that, for the most part, each of those transactions makes both parties better off, or otherwise they would not voluntarily trade. Unfortunately there isn’t any way to know exactly how much better off each trader is. A person takes an action iff they have no better alternatives to that action. We do not know their other alternatives, nor their subjective value of those alternatives, so we can’t know how much they gained because of the trade by looking at the prices and quantities at which the trades took place. Consumer surplus is a graphical representation of how much people gain from a market, compared to how they would have been without it. Consumer surplus is shown in the supply and demand graph as the triangle between equilibrium price and the demand curve.

Consumer Surplus

Consumer Surplus is the summation of the difference between each individual’s willingness to pay and the equilibrium price for all people who buy the good. So if 3 people bought a good for $5 and the first person was willing to pay $10, the second $8 and the third $6, the total consumer surplus would be (10-5) + (8-5) + (6-5) = $9. The gain from the other side of the exchange, producer surplus, is the amount producers gain by being able to sell their product, compared to what they could have sold using their scarce resources to produce the next best good. It is shown below:

Consumer Surplus

Both consumer and producer surpluses show opportunity costs, not subjective value. The surplus graphs are useful because they show how much cost can be imposed on someone before their behavior changes. For example, if my consumer surplus is $5, I can be charged a $4 tax and I will still purchase the good. If the tax is $6, I will not. However, without knowledge of the subjective value of a person’s alternatives, no measure of value can be gleaned from measures of either action or consumer surplus. Until advances in neuroscience are sufficient to record how much enjoyment a person feels, economic measures will continue to measure only choices and alternatives, not subjective value.

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2 Comments leave one →
  1. October 20, 2011 6:55 pm

    Thanks to Civ 4, I know this one! “Everything is worth what its purchaser will pay for it.”

    • October 20, 2011 7:55 pm

      Let’s say you are willing to $5 for bread. Where does that $5 come from? Willingness to pay is based on alternative uses for the money. You could buy rice or corn or fruit with the money instead. If you don’t buy the bread, you won’t starve, you’ll buy the next best food and eat that. It’s opportunity cost all the way down.

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