Consumer Surplus as an Inverse Measure of Sales Risk: Some International Implications

Abstract

By adopting a novel change in perspective on consumer surplus, it is possible to identify a type of general sales risk felt by firms. This risk can be conveniently implemented in deterministic models, just as in the past expected inflation was introduced into deterministic IS-LM models, hyperinflation models, etc. Firms facing demands with comparatively lower point price elasticity of demand will typically experience a lower sales risk than those facing demands with higher point price elasticity of demand. This sales risk at a given price is shown to depend in turn on the relative amounts of consumer surplus that exists at that price. Similarly movements in demand affect risk by altering the relative amounts of consumer surplus. A formal model of probabilistic demand is then proposed and equilibrium for the firm is determined. This equilibrium accords well with our understanding of profit being the reward for risk-taking. It is shown that a firm that increasingly attaches greater weight to expected profits at the expense of risk will tend to raise prices and thus restrict output. In addition, consumer surplus as a measure of risk sheds light on certain aspects of international economics, such as monopolistically competitive models of trade, the familiar Marshall-Lerner condition for competitive devaluations, gravity and location models of international trade, beggar-thy-neighbor policies, and hyperinflations.