MICROECONOMICS:

COMPENSATING VARIATION,
EQUIVALENT VARIATION,
CONSUMER SURPLUS, REVEALED
PREFERENCE
THE PROBLEM
 If there is a shift in demand for any reason (a tax, health scare,
change in preferences etc.) we want to be able to judge
whether the consumer is better or worse off.
 One possible way is to simply plug the new quantities of the
chosen goods back into the utility function:
 Problem is that UTILITY IS ORDINAL MEASURE:
 One can’t compare utility levels between individuals.
 The extent of the difference between utility levels is meaningless.
 We want a measurable, comparable, monetary value of the
change in welfare – this can be given in three forms:
 COMPENSATING VARIATION IN INCOME
 EQUIVALENT VARIATION IN INCOME
 CHANGE IN MARSHALLIAN CONSUMER SURPLUS
COMPENSATING VARIATION
 Consider a consumer with an Y
expenditure function of E(Px,...,U1).
 When there is an increase of Px to
Px’, the amount of income
compensation required to keep the
consumer on the original utility E(Px’,...,U1)
function U1 will be: E(Px’,...,U1)
 CV = E(Px’,...,U1) – E(Px,...,U1) CV
 This is shown on the diagram to the E(Px,...,U1)
right, where red is the initial
situation and blue is after the
price change.
 However, due to problems observing U1
people’s utility functions, we can
rarely observe the CV via this
method – Instead one has to use a E(Px,...,U1)
Compensated Demand Curve
(shown on a later slide). X
EQUIVALENT VARIATION
 Consider a consumer with Y
Expenditure function E(Px,...,U1).
 Price of X rises, as before, from Px
to Px’. E(Px’,...,U2)
 This puts the consumer on a
LOWER level of utility – U2. EV
 Equivalent Variation is the amount
of income we would have to E(Px,...,U2)
remove, at original prices, to put
the consumer on U2. U1
 EV = E(Px’,...,U2) – E(Px,...,U2)
 EV can also be shown using a
Compensated demand curve (later U2
slide), but considers a curve at the E(Px,...,U2)
NEW utility level, rather than the
old one (CV). E(Px’,...,U2)

X
MARSHALLIAN CONSUMER SURPLUS
 Equivalent Variation Vs. Compensating Variation:
 BOTH measure the distances of the two indifference curves,
but will depend on the slopes of the budget constraints.
 In general EV ≠ CV.
 That is, The amount of money a consumer is willing
to give up to avoid a price change is not equal to the
amount of money a consumer needs to be
compensated for a price change.

 Marshallian Consumer Surplus is the area below the

Marshallian demand curve and above the market price; it
shows what an individual would pay for the right to make
voluntary transactions at that price.
MARSHALLIAN CONSUMER SURPLUS
VS CV VS EV
Px
 In the case of a PRICE RISE:
 CV = Area under the
ORIGINAL compensated
demand curve. xc(Px,...,U1)
 CV = Px’.b.c.Px
 EV = Area under the NEW
compensated demand curve. a b
Px’
 EV = Px’.a.d.Px
 Δ MCS = Area under the
Marshallian Demand Curve. Px d c
 Δ MCS = Px’.a.c.Px x(Px,...,M)
 For a PRICE RISE:
 CV > Δ MCS > EV xc(Px,...,U2)
 For a PRICE FALL:
 EV > Δ MCS > CV X’ X X
REVEALED PREFERENCE
 We can’t directly observe preferences, making the past
analysis rather hypothetical.
 However, we can observe consumer behaviour and the
bundles of goods that they purchase.
 We can use this to indirectly reveal their preferences.

 Assumptions:
 Preferences are constant over the observed period.
 Consumer uses all their available income.
 For each price and income only one bundle is chosen.
 There exists only one price and income combination at which
each bundle is chosen.
REVEALED PREFERENCE
 Graphically, revealed Y
preference theory can be
shown as in the diagram.
 If initially the consumer
faces income ‘M’ and
chooses ‘B’ over ‘A’, then
B has been revealed
preferred to A.
B A
 The only time when A
would be chosen would be M’
either when B was
unavailable (M’) or
choosing B would violate M’’ M
one of the assumptions (M’’
– not using full income). X
REVEALED PREFERENCE – WARP &
SARP
 WEAK AXIOM of REVEALED PREFERENCE (WARP)
 If X and Y are two bundles that are both feasible and affordable to a
consumer and X is chosen over Y, then X has been DIRECTLY
REVEALED PREFERRED to Y.
 Y can NEVER be directly revealed preferred to X.

 STRONG AXIOM of REVEALED PREFERENCE

(SARP)
 If there are ‘n’ goods; A,B, ..., n, and A > B > C > ... > n, then A > n.
 A is INDIRECTLY REVEALED PREFERRED TO ‘n’, and ‘n’ can
NEVER be indirectly revealed preferred to A.
 SARP is essentially an expansion of WARP  to indirectly reveal
prefer goods, you must use directly revealed preferred goods as
steps along the road.
REVEALED PREFERENCE
 Solving Questions:
 When faced with a question on WARP, draw
a matrix of prices and bundles.
 For example, two goods ‘X’ and ‘Y’. In period
1, Px = 4, Py = 3; In period 2 Px = 3, Py = 3.
The consumer buys [X=2, Y=1] – BUNDLE 1 -
B1 | B 2

in period 1 and [X=1, Y = 2] – BUNDLE 2 - in
period 2. Is this consistent with WARP?
NO!
   
 The matrix shows why.
P1 10 10 
 
 Call the two Bundles ‘B1’ and B2’, and the
price combinations in the two periods P1 and
P2.



The Matrix shows the total cost of the two
bundles at the respective price combinations.
In Period 1, B1 has been directly revealed
P2  9 9 
preferred to B2.
 However, in period 2, BOTH ARE
AFFORDABLE, yet B2 is still chosen.
 This implies B2 has been directly R.P to B1,
which violates WARP.