Micro L12 Compensating & Equivalent Variation in Income, Consumer Surplus PDF

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Professor Martin Sefton
Compensating & Equivalent Variation in Income, Consumer Surplus...

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Lecture 12 – Compensating & Equivalent Variation in Income, Consumer Surplus We need to find measures that give us the monetary equivalent (£) of a utility change because we work with ordinal utility (ranking choices by order of preference). Compensating variation- how much money do we have to pay someone after a price increase to bring him/her back to his/her original utility level? 1. Start at point A. 2. Consumption choice after price increase: point B. 3. Pull the new budget constraint back (parallel) to the original indifference curve. 4. Vertical change in BC is the compensating variation (in £, because of the way we’ve defined ‘all other goods’). 5. Same approach as for compensated demand curves. Equivalent variation- given a consumer’s choice before a price increase, how much money would we have to take away from that consumer to reduce their utility by as much as the price increase? 1. Again start at the original bundle A. 2. The old budget constraint is moved (parallel) to the new indifference curve. 3. The vertical difference between the two budget constraints is the equivalent variation (again in £).

The values are generally different because they’re based on different relative prices Compensating- how much money required to compensate thee consumer given the NEW prices Equivalent- how much money needs to be taken away from the consumer given the OLD prices

Subsidies Consumer surplus It is only an APPROXIMATE measure of consumer welfare. It ignores income effects: - Along the demand curve, income is held constant - So, if we spend more on good A, we have less money to spend on other goods - marginal valuation argument assumes that utility from consuming A does not depend on how much money left for B (i.e. on the consumer’s income) - usually a good assumption if A only accounts for a very small share of total expenditure If we use compensated demand functions to calculate consumer surplus, we get the exact welfare change. - Eliminates income effects by construction - Can compute consumer surplus as before as the area below the (compensated) demand curve and above the price Why use the consumer surplus based on uncompensated demand curves at all? - Sometimes difficult to measure income effects. - For many goods, income effects of price changes are not very important, so consumer surplus changes derived from uncompensated demand functions are a good approx. -...