Consumer Surplus

1999, 2006,2010, 2011 by Peter

Berck
Money Measures
How much would you be willing to pay
(WTP) for a new ski area?
How much does it cost?
Shouldnt build unless total WTP is greater
than total cost.
Need WTP in $. Need a money measure.
Overview
TWTP and CS
Relation of EV, CV and CS
EV and CV for a publicly provided good
Adding over consumers
private good
public good\
WTA and WTP
Demand Curves

Demand: Amount that will be purchased as

a function of price p.
(Inverse) Demand: Price consumers will
pay for next unit as function of number of
units consumed, q.
P(Q) is willingness to pay for next unit
Marginal willingness to pay
Demand Slopes Down
willing to pay a lot more for the first pint of
water (especially on a hot day in the desert)
than for the pint after you have 40 gallons.
wtp decreases as quantity increases
Total Willingness to Pay
Total Willingness to pay is area under
demand.
demand price P(Q) is amount willing to pay for
next unit
So total willing to pay for Q units is P(1) +
P(2) + ...+ P(Q)
lower riemann sum and an approximation
the area under the demand curve between 0 and Q
units, which is the integral of demand, is (total)
willingness to pay
Calculating Total Willingness
70
60
50
40 AREA
Price

30 Demand
20
10
0
1 2 3 4 5 6 7
Quantity
Consumer Surplus
Consumer surplus is willingness to pay less
amount paid
Amount paid is P Q
Consumer surplus is willingness
to pay less amount paid
Willingness is blue + green. Surplus is
just the green

q
Willingness(Q)
The willingness to pay for q units is the
blue area while the willingness to pay
for q+n units is green and blue. Therefore
the willingness to pay for n extra units is
the green area
p

q q+n
Money Measures-Theory
Think of projects as lowering prices.
A new bridge lowers the price of crossing the
bay by making one wait less time in toll plaza
lines
A new ski area lowers price by making the
commute from LA to skiing be shorter
Lots of things
can be thought of as price changes
ipod mini brought price of carrying whole
music library around from essentially infinity to
$200.
new dam reduces price of electricity (because
there is more of it and demand curves slope
down.)
taxes, like environmental taxes, are price
increases.
Surplus and Price
Price increases from p to p. CS was
green+yellow+ orange. After increase
it is only green. CS changes by the wedge
that is yellow plus orange.

p
P

q q
CS is an Approximate Measure
and for markets goods a real
good approximation
at that.
When 1 unit bought demand
curve shifts in.
70
60
50
40 AREA
Price

30 Demand
20
10
0
1 2 3 4 5 6 7
Quantity
CS is easy
All you got to do is calculate an area.
All you need is a demand curve
Trouble is that CS is an approximate money
measure
Lets look at some exact money measures
and see how compare
Exact money measures
Equivalent Variation
Compensating Variation
For a normal good, consumer surplus is in
between these two measures. (Willigs
Theorem)
Equivalent Variation
A consumer actually faces an increase in the
price of a good from p0 to p1.
That will make his utility go down from one
indifference curve i to a lower indifference
curve ii.
Thought Experiment: $
Equivalent
If prices were left the same and instead
money was taken away from the consumer
How much money would you need to take
away to reduce the consumers utility from i to
ii?
That amount of money is EV
EV Picture
Narrating the picture
price doubled so now on new lower
indifference curve ii.
budget constraint III has original prices
(parallel to budget constraint I) but is
tangent to lower indiff curve ii.
read change in income between I and III on
the vertical axis (since the price of that
good is 1).
EV
The equivalent variation to a price change
from p0 to p1 is the change in income that
makes the consumer just as well off as if
prices had changed from p0 to p1.
to remember EV..
There are two equivalent ways to get the
consumer to the new utility level:
change income
change prices
CV
The compensating variation to a price
change from p0 to p1 is the change in
income that leaves the consumer just as
well off at price p1 as he would have been
with his original income at p0.
CV Picture
narrate cv
Start out on indifference curve i. The price
increases. Now you are on curve ii. How
much money needed to get back?
Budget constraint III has the new prices and
enough income to get back to old
indifference curve.
CV
The change in income compensates for the
change in price. The consumer is no better
or worse off than before.
Willig shows that CS isnt such a
bad idea after all.
for a price increase (for a normal good)
cv > CS > ev
For the example in the textbook all three of
these measures are within 63 cents and are
on the order of $107.
CS is more than good enough as a measure
for a private good.
Does CS work for goods that are
not bought?
Candy bars are bought. They are private
goods.
The level of bio-diversity/wolves/air quality
are all things that you cannot change by
personally buying more. They are publicly
provided goods.
Publicly Provided Goods
If the government provides a good and
people have different preferences
then some people wont get the amount they
like
People who can buy (or sell) a good all
have the price as their wtp for the next unit
of the good.
Not true if government gives the good.
 Wolves in the yellowstone ecosystem
some like em
some dont
some like em more than others
everyone gets the same numberthey are
just out thereget over it.
 Diagram on next slide
Has indifference curves. They are very
sharply curved to create an extreme
example.
You could draw some indifference curves not
quite so sharply curved and see if the general
point still works
Exact money measure for wolves
The reality is to get more wolves
Previous example was a higher price
Here it is a change in quantity
More wolves increase utility
EV is the amount of added $ that increases
utility the same as the added wolves
CV is the amount of money removed to
return to original level of utility
EV and CV for Publicly Provided
Good
35

30
i ii

25

20 A B
$

15

10
C
5

0
0 5 10 15 20 25 30 35
Wolves
EV and CV for Wolves
Starting from point A, we calculate CV for 5 more wolves
as follows. By adding 5 wolves, the consumer would be
on indifference curve ii at point B. To return to
indifference curve i, the consumer would need to give up
$10 in income, so the CV is $10. For EV, the question is,
how can we get the consumer back to indifference curve ii
without providing wolves? The consumer can get from
point A on i to point B on ii by adding 5 wolves, but even
an infinite amount of income will not get her to ii, holding
wolves constant; it will instead move her vertically along i.
Hence EV is infinite.
Publicly provided conclusion
If the indifference curves have are close to
square shaped
and the optimal amount (corners in this
case) are not provided
then ev and cv are very different.
 Loose Ends
So area under one persons demand is twtp
for that person.
How do we find twtp for a private good for
a market demand curve
Market demand = sum of individual demands
Same question for many people and a
public good.
 Private good
Market demand
For each price, add up the quantities each
consumer will buy. Horizontal addition of
individual demand curves.

QTotal ( P)
i consumers
Qi ( P )
TWTP private sum: horizontally
add demand and find area under

Q
 Public Good
P(Q) is marginal wtp (marginal means for
the next unit) for one person.
There are N people
N P(Q) is the what they are collectively
willing to pay. (why?)
Add vertically!
WTP for Public Good: vertically
add and find area under
40

35

30
Total Demand
25

20
$

15

Person 1's Person 2's

10 Demand Demand

0
0 10 20 30
Wolves

The marginal willingness to pay for a public good is the vertical sum of the individuals marginal willingness to pay values.
 CS, EV, CV , WTP blind
To the distribution of income.
We just find the twtp for each individual
and add them up. (Or take area under
market demand for private good).
Means each individuals $ count the same
Will these measures help you explain why
Egypt subsidizes bread?
 Valuation Questions
How do CV and EV relate to questions you
could ask people?
Willingness to pay
Willingness to accept
 Remember!
Utility Change is what
determines whether it is EV or
CV
change only happens with EV!
 WTP can lead to EV or CV
What is the most Most money willing to
money you would be pay so that ranchers
willing to pay to have wont kill wolves?
wolves in yellowstone Util goes down.
No util change so CV You pay or wolves die
EV
 WTA can lead to EV or CV
Least money willing Least money willing
to accept instead of to accept to allow
having increase in ranchers to kill
wolf numbers. wolves.
You get wolves or cash Wolves die,
Uitl changes But you get paid
EV Uitl constant
CV
Using WTP to explain a two or
more part tariff for Electricity
 Price Discrimination
Charging different Simplified electricity
consumers different tariff
prices. 10c/kwh for first
Could be the car 100kwh
Then 20c for all others
salesman who tries to
(inverted block)
get all the twtp
Each consumer buys Diff prices for diff
one car usage==diff prices for
different people
Simplified Problem:
Once $10b has been
paid to construct a
distribution system
Electricity costs
10c/kwh to generate
and distribute
How to price?
 If we charge 10c
Then marginal Supply is horizontal
willingness to pay will and equals demand
equal cost of where we produce.
producing next unit of But it wont recover
power. the 10b
Making more or less
power wont make any
one better off without
making someone else
worse off
 Where Should produce
suppose at 20c we cover the 10c
cost of power and the $10b
20c

10c S

q-high price=100b kwh

 Can we do better with a two part
tariff?

20c

10c S

D
q-high price q-10c price
 Charge $20 per mo. + 10c Kwh
Make up the fixed costs by charging a flat
fee per month plus the cost of the electric.
Works
 Politics (right wing
interpretation)
Voters want to make someone else pay.
Politicians call it concern for the poor.
Want to set electric rates to
Load fixed costs on a small minority
Pay off powerful interests
 Increasing Block Pricing
First $115/MWH up to baseline
Then Higher price till 130 percent of
baseline usage
Then $410/MWH
The fixed costs get covered by the people
who buy the most, who are also the richest
with the biggest pools.
 Public Utilities Commission
Covers costs
Overcharges minority of pool owners
Undercharges majority of renters
And the kicker.
Has special rates for industry that are even
lower than $115. Some ag rates where as low
as $50.