Monetary Measure of Welfare Change

 Suppose the price of gasoline

increases from $3 to $4 per gallon.
 Q: What is a dollar measure of the
decrease in welfare due to the
increase in price?
Monetary Measure of Welfare Change
 Three such measures are:
 Change in Consumer’s Surplus
 Compensating Variation, and
 Equivalent Variation.

 Only in one special circumstance do

these three measures coincide.
(Quasilinear Utility)
Agenda – Measuring Welfare
 Reservation Prices
 Consumer Surplus
 Value of Being In a Market
 Quasilinear Utility

 Compensating Variation
 Equivalent Variation
 ∆CS=CV=EV for Quasilinear Utility
 Producer Surplus
 Benefit-Cost Analysis
Reservation Prices
 Suppose gasoline can be bought only
in lumps of one gallon.
 Use r1 to denote the most a single
consumer would pay for a 1st gallon --
call this her reservation price for the 1st
gallon.
 The reservation price is the price at which
the consumer is indifferent between buying
and not buying the unit
 r1 is the dollar equivalent of the marginal
utility of the 1st gallon.
Calculating Reservation Prices
Rex’s utility over gallons of gasoline X and
money spent on other things Y is given by
U(X, Y) = (X+2)(Y+3). Rex has $100 to spend
on gasoline and other things. What is his
reservation price for the first gallon of
gasoline?
A) 206
B) 68.67
C) 65.67
D) 34.33
E) 56
Surplus
 Reservation prices are typically used
to estimate the most that someone
would pay for one unit when they can
only buy one unit: house, condo,
antique.
 If a consumer pays less for
something than their reservation
price, then the consumer has gotten
a surplus: r1 - p
Agenda – Measuring Welfare
 Reservation Prices
 Consumer Surplus
 Value of Being In a Market
 Quasilinear Utility

 Compensating Variation
 Equivalent Variation
 ∆CS=CV=EV for Quasilinear Utility
 Producer Surplus
 Benefit-Cost Analysis
Consumer Surplus

 An ordinary demand curve describes

the most that would be paid for q
units of a commodity purchased
simultaneously at the same price.

 Consumer surplus measures in

dollars the value to a consumer for
being able to purchase all the units
they want at a going price p.
Consumer Surplus

($/gal)
Ordinary demand curve for gasoline

Gasoline
Consumer Surplus

 The area under the ordinary demand

curve, above the price, up to the
quantity purchased is the
Consumer’s Surplus.
 Consumer surplus measures the
most a consumer would pay to enter
the market and buy units at the going
price.
Consumer Surplus

($/gal)
Ordinary demand curve for gasoline

Consumer’s Surplus

pG

Gasoline
Consumer Surplus & Price Changes

 How can we measure in dollars the

change in a consumer’s welfare due
to a change in the price of good 1, p1?
 One such measure is the change in
her Consumer Surplus.
 For this discussion, we’ll presume the
price increases.
Consumer Surplus & Price Changes
p1

p'1 CS before

x'1 x*1
Consumer Surplus & Price Changes
p1

p" CS after
1

p'1

x"
1 x'1 x*1
Consumer Surplus & Price Changes
p1

p"
1
Lost CS
p'1

x"
1 x'1 x*1
Consumer Surplus and
Quasilinear Utility
 Sometimes a researcher is interested
in a decision-makers consumption of
only one good.
 It is common to use quasilinear utility to
model preferences over the good (the
nonlinear part) and money spent on
everything else (the linear part).
Consumer Surplus and
Quasilinear Utility
The consumer’s utility function is
quasilinear in x2.
U(x1, x2)  v(x1)  x2
Take p2 = 1. Then the consumer’s
choice problem is to maximize
U(x1, x2)  v(x1)  x2
subject to
p1x1  x2  m.
Consumer Surplus and
Quasilinear Utility
 If the consumer’s utility function is
quasilinear (linear in money), and the
consumer is rich enough, then there
are no income effects on the
nonlinear good.
 In that case change in Consumer
Surplus is an exact $ measure of the
change in utility from purchasing the
good.
Agenda – Measuring Welfare
 Reservation Prices
 Consumer Surplus
 Value of Being In a Market
 Quasilinear Utility

 Compensating Variation
 Equivalent Variation
 ∆CS=CV=EV for Quasilinear Utility
 Producer Surplus
 Benefit-Cost Analysis
Compensating & Equivalent Variation

 Two additional dollar-measures of

the welfare change caused by a price
change are Compensating Variation
and Equivalent Variation.
Compensating Variation

 p1 rises.
 Q: What is the least extra income
that, at the new prices, just restores
the consumer’s original utility level?
Compensating Variation

 p1 rises.
 Q: What is the least extra income
that, at the new prices, just restores
the consumer’s original utility level?
 A: The Compensating Variation.
 The Compensating Variation is the
amount of money you have to give the
consumer after the price rise to
compensate them for the price increase
Compensating Variation
p1=p1’ p2 is fixed.
x2 p1=p1” ' ' '
m1  p1x1  p2x2
" " "
 p1x1  p2x2
x"2
x'2
u1
u2
"
x1 x'1 x1
Compensating Variation
p1=p1’ p2 is fixed.
x2 p1=p1” ' ' '
''' m1  p1x1  p2x2
x 2 " " "
 p1x1  p2x2
x"2
x'2 m2  p x  p2 x
"
1
'"
1
'"
2
u1
u2 CV = m2 - m1
"
x1 x'"
1 x'1 x1
Equivalent Variation

 p1 rises.
 Q: What is the least extra income
that, at the original prices, just leaves
the consumer at the new utility level?
 A: The Equivalent Variation.
 The Equivalent Variation is the money
loss a consumer would consider to be
equivalent to the price increase…
 the amount of money a consumer would
pay to avoid the price increase.
Equivalent Variation
p1=p1’ p2 is fixed.
x2 p1=p1” ' ' '
m1  p1x1  p2x2
" " "
 p1x1  p2x2
x"2
x'2
u1
u2
"
x1 x'1 x1
Equivalent Variation
p1=p1’ p2 is fixed.
x2 p1=p1” ' ' '
m1  p1x1  p2x2
" " "
 p1x1  p2x2
x"2
x'2 m2  p x  p2 x
'
1
'"
1
'"
2
''' u1
x 2
u2 EV = m1 - m2
" '
x1 x'"
1 x1 x1
Agenda – Measuring Welfare
 Reservation Prices
 Consumer Surplus
 Value of Being In a Market
 Quasilinear Utility

 Compensating Variation
 Equivalent Variation
 ∆CS=CV=EV for Quasilinear Utility
 Producer Surplus
 Benefit-Cost Analysis
Consumer’s Surplus, Compensating
Variation and Equivalent Variation
 Relationship 1: When the
consumer’s preferences are
quasilinear
U(x1, x2)  v(x1)  x2
 and p2 = 1 and p1 rises, then these
three measures: compensating
variation, equivalent variation, and
change in consumer surplus are all
the same.
Consumer’s Surplus, Compensating
Variation and Equivalent Variation
So when the consumer has quasilinear
utility (linear in good 2), and p1 rises, then
DUtility = CV = EV = DCS.

Otherwise, if p1 rises we have

Relationship 2: In size, EV ≤ DCS ≤ CV.

Agenda – Measuring Welfare
 Reservation Prices
 Consumer Surplus
 Value of Being In a Market
 Quasilinear Utility

 Compensating Variation
 Equivalent Variation
 ∆CS=CV=EV for Quasilinear Utility
 Producer Surplus
 Benefit-Cost Analysis
Producer’s Surplus

 Changes in a firm’s welfare can be

measured in dollars, much as for a
consumer.
Producer’s Surplus
Output price (p)

Marginal Cost
'
p
Revenue
' '
= py

y' y (output units)

Producer’s Surplus
Output price (p)

Marginal Cost
'
p
Variable Cost of producing
y’ units is the sum of the
marginal costs

y' y (output units)

Producer’s Surplus
Output price (p)
Revenue minus VC
is the Producer’s
Surplus. Marginal Cost
'
p
Variable Cost of producing
y’ units is the sum of the
marginal costs

y' y (output units)

Agenda – Measuring Welfare
 Reservation Prices
 Consumer Surplus
 Value of Being In a Market
 Quasilinear Utility

 Compensating Variation
 Equivalent Variation
 ∆CS=CV=EV for Quasilinear Utility
 Producer Surplus
 Benefit-Cost Analysis
Benefit-Cost Analysis
 Can we measure in money units the
net gain, or loss, caused by a market
intervention; e.g., the imposition or
the removal of a market regulation?
 Yes, by using measures such as the
Consumer’s Surplus and the
Producer’s Surplus.
Benefit-Cost Analysis
Price The free-market equilibrium
and the gains from trade
generated by it. Supply

CS
p0
PS

Demand

q0 QD , Q S
(output units)
Benefit-Cost Analysis
Price The gains from freely
trading the units from
q1 to q0. Supply
Consumer’s
gains
CS
p0
PS
Producer’s
gains
Demand

q1 q0 QD , Q S
(output units)
Benefit-Cost Analysis
Price

Any regulation that

Consumer’s causes the units
gains from q1 to q0 to not
CS be traded destroys
p0 these gains. This
PS loss is the net cost
Producer’s
gains of the regulation.

q1 q0 QD , Q S
(output units)
Benefit-Cost Analysis
Price An excise tax imposed at a rate of $t
per traded unit destroys these gains.
Deadweight
CS Loss
pb
Tax
t Revenue
ps
PS

q1 q0 QD , Q S
(output units)
Benefit-Cost Analysis
Price An excise tax imposed at a rate of $t
per traded unit destroys these gains.
Deadweight So does a floor
CS Loss price set at pf
pf

PS

q1 q0 QD , Q S
(output units)
Benefit-Cost Analysis
Price An excise tax imposed at a rate of $t
per traded unit destroys these gains.
Deadweight So does a floor
Loss price set at pf,
or a ceiling price
CS set at pc

pc
PS

q1 q0 QD , Q S
(output units)
Agenda – Measuring Welfare
 Reservation Prices
 Consumer Surplus
 Value of Being In a Market
 Quasilinear Utility

 Compensating Variation
 Equivalent Variation
 ∆CS=CV=EV for Quasilinear Utility
 Producer Surplus
 Benefit-Cost Analysis
Economics 401 Intermediate Micro

 Instructor: Chris Proulx

[email protected]

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