Measuring Welfare

Changes

Chapter 4
 Observability Problem
 Utility levels are unobservable
 Indirect measures are needed to capture
changes in welfare due to specific
government policies
 Revealed preferences approach
 Observe consumers’ behavior
 Infer their preferences

 Evaluate changes in consumers’ welfare

based on those preferences
Consumer Surplus and the Demand Curve
– A consumer’s willingness to pay for a good is the
maximum price at which he or she would buy that good.
– Individual consumer surplus is the net gain to an
individual buyer from the purchase of a good. It is equal
to the difference between the buyer’s willingness to pay
and the price paid.
The Demand Curve for Used Textbooks
Price of
book
$59 Aleisha Potential Willingness
buyers to pay
Aleisha $59
45 Brad Brad 45
Claudia 35
35 Claudia Darren 25
Edwina 10
25 Darren

A consumer’s
10 Edwina willingness to pay for a
D good is the maximum
0 1 2 3 4 5
Quantity of books price at which he or she
would buy that good.
 Willingness to Pay and Consumer Surplus

– Total consumer surplus is the sum of the individual

consumer surpluses of all the buyers of a good.

– The term consumer surplus is often used to refer to

both individual and total consumer surplus.
Consumer Surplus in the Used Textbook Market

Price of
book Aleisha’s consumer
surplus:
$59-$30=$29
$59 Aleisha
Brad’s consumer
surplus:
$45-$30=$15 The total consumer
45 Brad
Claudia’s consumer surplus is given by the
surplus: $35-$30=$5
35 Claudia
entire shaded area - the
30 Price = $30
sum of the individual
25 Darren
consumer surpluses of
Aleisha, Brad, and
Claudia - equal to $29 +
10 Edwina
$15 + $5 = $49.

D
0 1 2 3 4 5 Quantity of books
Consumer Surplus in the Used Textbook Market
Consumer Surplus
The total consumer surplus
Price of generated by purchases of
computers
a good at a given price is
equal to the area below the
demand curve but above
that price.
Consumer
surplus

$1,500 Price = $1,500

0 1 million
Quantity of computers
How Changing Prices Affect Consumer Surplus

– A fall in the price of a good increases consumer surplus

through two channels:
• A gain to consumers who would have bought at the
original price and
• A gain to consumers who are persuaded to buy by the
lower price.
Consumer Surplus and a Fall in the Price of Used
Textbooks
Price of
book
Increase in
$59 Aleisha’s consumer
Aleisha
surplus
Increase in Brad’s
consumer surplus
45 Brad

Increase in Claude’s
35 Claudia consumer surplus
30 Original price = $30
25 Darren

20 New price = $20

Darren’s consumer
10 Edwina surplus

D
0 1 2 3 4 5
Quantity of books
A Fall in the Market Price Increases Consumer Surplus
Price of
computers

Increase in consumer
surplus to original
$5,000 buyers

Consumer
surplus gained
by new buyers

1,500

0 200,000 1 million Quantity of computers

 Multiple Price Changes
• Policy changes may affect several prices

• Consider two markets, and a price change in

each

• Can we sum up the two changes in two

consumer surpluses so as to compute total
change in consumer surplus?

• It turns out, the result may be ambiguous

 Multiple Price Changes:
An Example
P1 P2 In the second market, the
The price of commodity 1 price is lowered down to $7
falls to $8
The price change in the
Consumer surplus
12 FIRST market shifts
goes up by A
demand in the SECOND
market outwards,
surplus up by B+C
10
A B C
8
7

X1 X2
Consumer surplus in both markets is up by A+B+C
 Multiple Price Changes:
An Example
P1 P2 Reverse the order: lower P2
Demand in the FIRST first: consumer surplus up
market shifts outward, by B
and the policy brings P1
12
down, too

10
A D B
8
7

X1 X2
Consumer surplus in both markets is up by A+B+D
 Multiple Price Changes
 We obtain TWO different consumer
surplus changes
 In general, A+B+C does not have to be
equal to A+B+D
 The order of price changes matters
 This phenomenon is called path
dependence
 Multiple Price Changes
 If prices move in different directions,
changes in consumer surplus may be
opposite in sign to changes in welfare
 Path-dependency problem is avoided if
we look at changes in consumer utility
rather than consumer surpluses
 Restricting Preferences
 In the example, the problem arises
because C is not equal to D

 Two forms of utility functions that

produce the same rankings as the ones
based on consumer surpluses changes
 Homothetic utility functions
 Quasi-linear utility functions
Income Expansion Path
Income expansion path is the
locus of all consumption
bundles obtained as we keep
on increasing income

Prices stay the same as

income goes up

The proportion of physical

units in which X and Y are
consumed (and MRS)
changes with income
 Homothetic Preferences
 In case the marginal rate of substitution
only depends on the ratio of the two
goods, income expansion paths are
straight lines emanating from the origin
 It happens because demand for both
goods grows proportionately to
changes in income
 Cobb-Douglas utility function belongs
to that class:  
U  Ax1 x2
 HOMOTHETICITY
Income expansion paths are straight
lines through the origin

X2

X1
 Cobb-Douglas Case
 Demand functions in case utility is of
Cobb-Douglas type do not depend on
the other good’s price:

x1  f  p1 y

 Therefore, demand does not shift in

case of a price change in the other
market, and C=D=0 in our example
More General Homothetic Case
 Some homothetic utility functions
generate demand functions that depend
on all prices

 Nevertheless, changes in consumer

surplus in both markets are the same
irrespective of the order in which prices
in the two markets change
Quasi-Linear Utility Functions
 All demands, except for just one, are
independent of income

 Any increase in income is spent on just

one commodity
 Quasi-Linear
Income Expansion Path
X2

All additional income is spent on commodity

X2

U  x1  x2

X1
Income and Substitution Effects
Substitution effect is an increase
in commodity B consumption if
price change is not allowed to
change the consumer’s utility level

Income effect is an increase in

commodity B consumption that
would have occurred under the
new prices ONLY as a result of
an increase in his purchasing
power
Quasi-Linear Preferences:
Income and Substitution Effects
 All additional income is spent on just one commodity
 Let there be some third commodity on which all
additional income is spent
 Then income effects for the other two commodities
are absent since demands are affected only by the
substitution effects
 The two substitution effects are symmetric
 Area C is equal to area D, and there is no
path-dependency!
 Using Consumer Surplus
to Evaluate Policy Changes
 In general, the result depends on the
order in which prices change
 The result is the same as the one given
by changes in utility function values if:
 Preferences are homothetic
 Preferences are quasi-linear

 Do many consumers really behave in

that way?
 Aggregation of Consumer
Surplus
 Suppose now there are TWO households
 A single price is changed
 Aggregate consumer surplus goes up by
A+B
Market demand

Demand of

consumer A
A B
 Two Consumers: Example
 Price of X1 is lowered
 Price of X2 is raised
 Consumer 1 consumes only X1
 Consumer 2 consumes only X2
 Let increase in surplus for consumer 1 be S
 Suppose the loss in surplus for
consumer 2 is –S
 In the aggregate, nothing has changed
 Two Consumers: an Example
 The aggregate change in consumer
surplus is zero
 However, the sum of changes in
consumers’ utilities can be anything:
zero, positive, or negative
 Suppose the marginal utilities of an extra
dollar for the two consumers are equal to
and : for example, if I give $1 to
1 2
consumer 1, his utility grows by
1
Marginal Utilities of an
Extra Dollar
 The total change in social welfare due
to the lowered P1 and raised P2 is
not equal to change in aggregate CS:

W  1S  2 S  0


Only when total welfare is maximized, marginal utilities of an extra

dollar are equal across individuals, so the total welfare change is
zero.
Problems with Ordinary Demand
 Demand curves considered so far are
called ordinary, or Marshallian demand
curves
 Marshallian demand has problems:
 Path-dependency in case consumer
surplus is measured as area to the left of
Marshallian demand
 Equality of marginal utilities of income is
questionable since cardinal utilities are, too
Compensating and Equivalent
Variations
 Consider a fall in the price of one good

 Ex post approach:
 How much money can you give to a consumer so as to
make him as well off as he was before the price went up?
 Compensating variation

 Ex ante approach:
 How much money do you take away from the consumer
before the price went up so as to harm him as much as the
more expensive price would?
 Equivalent variation
 Compensating Variation

Ex post, we can compensate by Compensating variation

C this much to get the consumer is how much we must
V back to original utility level give to the consumer to
compensate for the more
expensive price

Original budget
constraint

Budget constraint
with expensive
medical care
 Equivalent Variation

Equivalent variation is the

amount of lost income that
Ex ante, taking away this does as much harm
much will harm consumer (is equivalent to) as the
just as much as the price rise price increase
E would
V
Original budget
constraint

Original
Budget constraint
budget line
with expensive
medical care
Compensated Demand Curves

These quantities demanded

will be greater than at c, the
After some income uncompensated change in
have been taken demand.
away from, or given
to, the consumer,
his demand
quantities will be b
or d
 Compensated Demand Curves
When we give to, or take away from a consumer, a certain part of income,
we arrive at a different demand quantity for any given price.

The demand quantities are thus getting adjusted for income compensation,
leading to the compensated demand curves.

P
Compensated demand curves
are steeper since the income
Compensated demand curve effect is absent.

Ordinary demand curve

Q
 Properties of CV and EV
 CV for a price fall is equal to minus EV for a reversed
price rise

 For a normal good, CV<S<EV, where S is ordinary

consumer surplus

 The relative error of using CV and EV instead of S is

proportional to the income elasticity of demand
 Income Elasticity of Demand
 Income elasticity of demand is a percentage change
in demand in response to a 1% increase in income

 High values of income elasticity of demand mean

consumers are sensitive to changes in income (e.g.
drastically reduce their consumption if their salary
decreases)

 The more sensitive consumers are to income, the

greater the error will be of using S instead of CV or
EV
Consistent Ranking
by CV and EV: One Price
 If a particular change in one price
increases consumer welfare, both CV
and EV will have positive signs
 For a given change in one price, EV>CV
 For two or more prices EV is not
necessarily greater than CV
 However, ranking by EV or CV will be
consistent if we compare just two
bundles
 Ranking by CV:
Multiple Bundles
 Suppose we change prices and incomes in two different ways
so that the consumer ends up with two consumption bundles,
albeit enjoying the same utility

 We can obtain two CV measures of welfare change

 These two CV measures are in general different from each other

 Hence, one way of changing the price and income will be

preferred to another

 However, this is inconsistent with saying that both income/price

changes result in the same utility
 CV Ranking: Inconsistency
Budget Line 2
CV2
Both price/income changes result in
the same utitlity level, but CV2 is not
equal to CV1

CV1

Budget Line 1
 EV Ranking
 Equivalent variation “shifts” the original
budget line according to the original
prices so it ends up being at the same
location

 As a result, EV ranking is consistent

 EV ranks any number of bundles in a

consistent manner
 Two Initial Bundles
 If there are two initial bundles, but only
one final bundle, the situation is reversed
 EV ranking is inconsistent
 CV ranking is consistent
 Hence, neither CV nor EV can be
regarded as a dollar equivalent of utility
change
 CV, EV, Hicks and Kaldor
 A positive aggregated CV is necessary,
but not sufficient, for Kaldor test to be
passed
 A positive aggregated EV is sufficient,
but not necessary, to pass Hicks test
 However, the reversal example (Chapter
3) indicates that CV is not necessarily
equivalent to EV
Measuring Producers’ Welfare
 Firms maximize profits, not utility

 Firms face costs, not budget constraints

 Producer surplus: area below the price,

and above the (short-run) supply curve
Firm’s Producer Surplus
Producer Surplus + Total Cost = Total Revenue

Producer
Surplus

Total Cost
Producer Surplus and
Increase in Wage
 Producer Case
 No path-dependency problem (simply
take the difference between two profits)