8/3/2009

1
Lecture 8
Ways to Measure Utility:
Consumers Surplus, Compensating
and Equivalent Variations
Consumers Surplus: Discrete good
Consumers Surplus: Continuous Demand
Compensating and Equivalent Variation
Producers Surplus
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Demand for a Discrete Good
demand for a discrete good with a quasilinear utility.
utility function takes the form:
the x good is the discrete good and the y good is the
money to be spent on other goods (price is 1).
Consumer behavior was described in terms of
reservation prices:
y x v u + = ) (
).... 1 ( ) 2 (
) 0 ( ) 1 (
2
1
v v r
v v r
=
=
Relationship between reservation prices and demand: if n
units was demanded, then:
Example: If 6 units are consumed at price p, utility of
consuming (6,m-6p) must be at least as large as consuming
any other bundle (x, m-p
x
):
1 +
> >
n n
r p r
7
6
) 6 ( ) 7 (
g rearrangin
7 ) 7 ( 6 ) 6 (
: also
) 5 ( ) 6 (
g rearrangin
5 ) 5 ( 6 ) 6 (
r v v p
p m v p m v
p r v v
p m v p m v
= >
+ > +
> =
+ > +
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Constructing Utility from Demand
Since the reservation prices are just the differences in
utility, add up the reservation prices to come with total
utility associated with consumption of x units.
If we set v(0) is equal to zero, the utility associated with
consuming n units = sum of the first n reservation
prices.
3 2 1
3
2
1
) 0 ( ) 3 (
) 2 ( ) 3 (
) 1 ( ) 2 (
) 0 ( ) 1 (
r r r v v
v v r
v v r
v v r
+ + =
=
=
=

A plot of r
1
, r
2
, , r
n
, against n is a
reservation-price curve.
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Gross benefit or gross consumers surplus associated
with the first n consumed of good 1 is therefore the area
of the first n bars which make up the demand function.
Consumers surplus or net consumers surplus
measures the net benefits from consuming the n units
of the discrete good.
final utility of consumption depends on both good 1 and good 2
Therefore, in the discrete good example, the consumption of
good 2 is m-pn. The total utility is therefore v(n)-m-pn.
is called the consumers surplus or net consumers
surplus.
It measures the utility v(n) minus the reduction in expenditure on
the consumption of the other good.
pn n v ) (
Reservation Price Curve
Quantity
($) Res.
Values
1 2 3
4
5 6
r
1
r
2
r
3
r
4
r
5
r
6
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Reservation Price Curve
Quantity
($) Res.
Values
1 2 3 4 5 6
r
1
r
2
r
3
r
4
r
5
r
6
p
G
Reservation Price Curve
Quantity
($) Res.
Values
1 2 3 4
5 6
r
1
r
2
r
3
r
4
r
5
r
6
p
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Reservation Price Curve
Quantity
($) Res.
Values
1
2 3
4
5
6
r
1
r
2
r
3
r
4
r
5
r
6
p
Consumers surplus
Consumer surplus can be interpreted as the
excess of value placed on a unit of
consumption over the price that he has to pay
for it:
Adding up over all n units that the consumer
chooses, the total consumer surplus is:
Since the sum of the reservation prices just gives
the utility, then this can be rewritten as:
p r
np r r r CS
n
+ + = ...
2 1
pn n v CS = ) (
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Consumers surplus can also be interpreted as
the amount of money that a consumer has to
be paid in order for him to give up his entire
consumption of that good
Let R be that amount of money, R must satisfy:
Since v(0)=0, then by definition, the equation
reduces to:
pn m n v R m v + = + + ) ( ) 0 (
pn n v R = ) (
Consumers surplus can be generated from
consumers surplus. The former refers to
the sum of surpluses across a number of
consumers. Thus if we have measures of
single consumer surpluses, then we can
add these all up to come up with an
aggregate measure.
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Extend the case of a discrete good to the
case of continuous quantities by
approximating the continuous demand
curve by a staircase demand curve.
The area under the continuous demand curve
is therefore approximately equal to the area
under the staircase demand.
Suppose that good 1 is sold in half-units.
r
1
, r
2
, , r
n
, denote the consumers
reservation prices for successive unit of x
1
.
Our consumers new reservation price curve
is
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Reservation Price Curve
Half units
($) Res.
Values
1 2 3 4 5 6
r
1
r
3
r
5
r
7
r
9
r
11
7
8
9 10 11
Reservation Price Curve
Half units
($) Res.
Values
1
2
3
4 5
6
r
1
r
3
r
5
r
7
r
9
r
11
7
8 9
10 11
p
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Reservation Price Curve
Half units
($) Res.
Values
1 2
3 4
5 6
r
1
r
3
r
5
r
7
r
9
r
11
7 8
9
10 11
p
G
Consumers surplus
And if good 1 is available in one-quarter
units ...
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Reservation Price Curve
0
2
4
6
8
10
One quarter units
($) Res.
Values
1
Reservation Price Curve
0
2
4
6
8
10
One quarter units
($) Res.
Values
1
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Reservation Price Curve for Gasoline
0
2
4
6
8
10
($) Res.
Values
p
P value of net utility gains-to-trade
Finally, if good 1 can be purchased in any
quantity then ...
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Good 1
(P) Res.
Prices
Reservation Price Curve
Good 1
(P) Res.
Prices
p
Reservation Price Curve
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Good 1
(P) Res.
Prices
p
Reservation Price Curve
Consumers surplus
However, using the area under the demand curve as
a measure of utility is only exactly correct when the
utility function is quasilinear.
reservation prices are independent of the amount of
money the consumer has to spend on other goods -
there is no income effect
it is a good approximation if demand for a good doesnt
change very much when income changes.
In general though, reservation prices for good 1 will
depend on how much good 2 is being consumed.
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Changes in Consumers Surplus
Changes in consumers surplus are helpful in
analyzing policy changes.
For instance, if we want to analyze a price
change owing to some government project.
How will the consumers surplus change?
The change to a consumers total utility due
to a change in p
1
is approximately the
change in her Consumers Surplus.
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Suppose, prices increase from p to p.
Difference is roughly the difference between two
triangular areas. The difference is roughly
trapezoidal in shape with two regions R and T.
R represents the loss in surplus because the
consumer is paying more for all the units that he
consumes. This is the area (p-p)x.
T represents the value of lost consumption
because the consumer has decided to consume
less because of the price increase.
The total loss to the consumer is the sum of
these two effects: the loss from having to pay
more for the units he consumes and the loss
from reduced consumption
p
1
x
1
*
x
1
'
p
1
'
p
1
(x
1
), the inverse ordinary demand
curve for commodity 1
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p
1
x
1
*
x
1
'
CS before
p
1
(x
1
)
p
1
'
p
1
x
1
*
x
1
'
CS after
p
1
"
x
1
"
p
1
(x
1
)
p
1
'
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R
p
1
x
1
*
x
1
'
x
1
"
Change in CS= R + T
p
1
(x
1
), inverse ordinary demand
curve for commodity 1.
p
1
"
p
1
'
T
Example: A linear demand curve:
When the price changes from 2 to 3, what is the
change in consumers surplus?
When p=2, D=16 and when p=3, D=14.
Compute an area of a trapezoid with a height of 1
and base of 14. This is the sum of a rectangle with
a height of base 1 and base 14 and of a rectangle
with a height of 1 and base of 2.
The area is therefore 15.
p p D 2 20 ) ( =
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Alternative measure of utility changes without using
consumers surplus.
Two issues involved:
How to estimate utility when a number of consumer choices
are observed.
How to measure utility in money units
First issue:
With enough observations on demand behavior and that
behavior is consistent with maximizing something, then
we will generally be able to estimate the function that is
being maximized, e.g. Cobb-Douglas
Use the function to evaluate the impact of proposed
changes in prices and consumption levels.
Use monetary measures of utility convenient in
some applications.
Expressed as how much money would have to be given
to a consumer in order to compensate him for a change
in his consumption patterns.
Two ways are usually utilized: compensating variation
and equivalent variation
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Defined as the change in income necessary
to restore the consumer to his original
indifference curve.
How much money would have to be given to
the consumer after the price change to
make him just as well off as he was before
the price change
p
1
rises.
Q: What is the least extra income that, at the
new prices, just restores the consumers
original utility level?
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p
1
rises.
Q: What is the least extra income that, at the
new prices, just restores the consumers
original utility level?
A: The Compensating Variation.
x
2
x
1
x
1
'
u
1
x
2
'
p
1
=p
1
p
2
is fixed.
m p x p x
1 1 1 2 2
= +
' ' '
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x
2
x
1
x
1
'
x
2
'
x
1
"
x
2
"
u
1
u
2
p
1
=p
1

p
1
=p
1

p
2
is fixed.
m p x p x
1 1 1 2 2
= +
' ' '
= + p x p x
1 1 2 2
" " "
x
2
x
1
x
1
'
u
1
u
2
x
1
"
x
2
"
x
2
'
x
2
'"
x
1
'"
p
1
=p
1

p
1
=p
1

p
2
is fixed.
m p x p x
1 1 1 2 2
= +
' ' '
= + p x p x
1 1 2 2
" " "
'"
2 2
'"
1
"
1 2
x p x p m + =
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x
2
x
1
x
1
'
u
1
u
2
x
1
"
x
2
"
x
2
'
x
2
'"
x
1
'"
p
1
=p
1

p
1
=p
1

p
2
is fixed.
m p x p x
1 1 1 2 2
= +
' ' '
= + p x p x
1 1 2 2
" " "
'"
2 2
'"
1
"
1 2
x p x p m + =
CV = m
2
- m
1
.
Measures the maximum amount of income that the
consumer would be willing to pay to avoid the price
change.
How much money would have to be taken away from the
consumer before the price change to leave him as well
off as he would be after the price change.
Depicted as how far down we must shift the original
budget line to just touch the indifference curve that
passes through the new consumption bundle.Fig.4
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p
1
rises.
Q: What is the least extra income that, at the
original prices, just restores the consumers
original utility level?
A: The Equivalent Variation.
x
2
x
1
x
1
'
u
1
x
2
'
p
1
=p
1
p
2
is fixed.
m p x p x
1 1 1 2 2
= +
' ' '
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x
2
x
1
x
1
'
x
2
'
x
1
"
x
2
"
u
1
u
2
p
1
=p
1

p
1
=p
1

p
2
is fixed.
m p x p x
1 1 1 2 2
= +
' ' '
= + p x p x
1 1 2 2
" " "
x
2
x
1
x
1
'
u
1
u
2
x
1
"
x
2
"
x
2
'
x
2
'"
x
1
'"
p
1
=p
1

p
1
=p
1

p
2
is fixed.
m p x p x
1 1 1 2 2
= +
' ' '
= + p x p x
1 1 2 2
" " "
m p x p x
2 1 1 2 2
= +
' '" '"
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x
2
x
1
x
1
'
u
1
u
2
x
1
"
x
2
"
x
2
'
x
2
'"
x
1
'"
p
1
=p
1

p
1
=p
1

p
2
is fixed.
m p x p x
1 1 1 2 2
= +
' ' '
= + p x p x
1 1 2 2
" " "
m p x p x
2 1 1 2 2
= +
' '" '"
EV = m
1
- m
2
.
CV vs EV
Amount of money that consumer would be willing to pay to
avoid a price change amount of money that would have to
be paid to a consumer to compensate him for a price change
Reason: a peso is worth differently to a consumer at different
sets of prices because it will purchase different amounts of
consumption.
CV and EV are just two ways of measuring the distance
between indifference curves by seeing how far apart the
tangent lines are. Since the distance depend on the tangent
lines, it matters from what price level you are proceeding.
CV, EV and consumers surplus are equal in the case of
quasilinear utility.
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Example:
Suppose:
prices are (1,1) and income is 100. Let the price of
good 1 increase to 2.
Demand for these Cobb-Douglas u functions are:
the original demanded bundle is (50,50) and the
new bundle is (25,50)
2 / 1
2
2 / 1
1 2 1
) , ( x x x x u =
2 2 1 1
2 / and 2 / p m x p m x = =
Compensating variation: How much money would be
necessary at prices (2,1) to make him as well off as he
was consuming bundle (50,50)?
At the new prices and at the level of income with the
compensating variation, m, the consumer would be
consuming (m/4,m/2).
Setting the utility of this bundle with the original bundle, we
can solve for m.

Solving for m, m is approximately 141. Therefore, the

consumer would need about 41 pesos to make him as well
off as before.
2 / 1 2 / 1
2 / 1 2 / 1
50 50
2 4
= |
.
|

\
|
|
.
|

\
| m m
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Equivalent variation: How much money
would be necessary at prices (1,1) to make
the consumer as well off as he would be
consuming bundle (25,50).
Letting m be the amount of money, and
following the same logic:
Solving for m gives m approximately equal to
70. The equivalent variation is therefore 30.
2 / 1 2 / 1
2 / 1 2 / 1
50 25
2 2
=
|
.
|

\
|
|
.
|

\
| m m
Example: CV and EV using quasilinear
preferences
Suppose a quasilinear function:
Demand for good 1 depends only on the prices of
good 1:
Suppose prices change from .
Demands and utilities are:
2 1
) ( x x v +
) (
1 1 1
p x x =
1
*
1
to
.
p p
1
1
1
1
1
*
1
*
1
*
1
*
1
*
1
) ( ), (
) ( ), (
. . . . .
+
+
x p m x v p x
x p m x v p x
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Compensating variation, C, amount of
money that consumer would need after
the price change to make him as well off:
Solving for C:
*
1
*
1
*
1
1
1
1
) ( ) ( x p m x v x p C m x v + = + +
. . .
*
1
*
1
1
1
1
*
1
) ( ) ( x p x p x v x v C + =
. . .
Equivalent variation, E, satisfies the
equation:
Solving for E:
*
1
*
1
*
1
1
1
1
) ( ) ( x p E m x v x p m x v + = +
. . .
*
1
*
1
1
1
1
*
1
) ( ) ( x p x p x v x v E + =
. . .
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Thus C=E.
They are also equal to the change in net
consumers surplus:
Recall:
] ) ( [ ] ) ( [ 1
1
1
*
1
*
1
*
1
. . .
= A x p x v x p x v CS
pn n v CS = ) (
Supply curve measures the amount that will be
supplied at each price. Area above the supply curve
is the producers surplus. It measures the surplus
enjoyed by the suppliers of the good.
Conduct the analysis in terms of the producers
inverse supply curve p
s
(x). This function measures
what the price would have to be to get the producer
to supply x units of the good.
Analogue would be the analysis for a discrete good. While
the producer is willing to supply the first n units at a supply
reservation price, what he actually gets is higher. The
excess is the producers surplus.
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Changes in a firms welfare can be measured
in pesos much as for a consumer.
y
(output units)
Output price (p)
Marginal Cost
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y
(output units)
Output price (p)
Marginal Cost
p
'
y
'
y
(output units)
Output price (p)
Marginal Cost
p
'
y
'
Revenue
=
p y
' '
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y
(output units)
Output price (p)
Marginal Cost
p
'
y
'
Variable Cost of producing
y units is the sum of the
marginal costs
y
(output units)
Output price (p)
Marginal Cost
p
'
y
'
Variable Cost of producing
y units is the sum of the
marginal costs
Revenue less VC
is the Producers
Surplus.
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Net producers surplus=difference between the
minimum amount that she would be willing to
sell the x* units for and the amount she actually
sells the unit for.
What is the change in the surplus when there is
a price increase from p to p. R measures the
gain from selling the units previously sold at a
higher price. T measures the gain from selling
the extra units at a higher price.
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
Consumers Surplus and the Producers
Surplus.
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Q
D
, Q
S
(output units)
Price
Supply
Demand
p
0
q
0
The free-market equilibrium
CS
Q
D
, Q
S
(output units)
Price
Supply
Demand
p
0
q
0
The free-market equilibrium
and the gains from trade
generated by it.
PS
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CS
Q
D
, Q
S
(output units)
Price
Supply
Demand
p
0
q
0
PS
q
1
Consumers
gain
Producers
gain
The gain from freely
trading the q
1
th
unit.
CS
Q
D
, Q
S
(output units)
Price
Supply
Demand
p
0
q
0
The gains from freely
trading the units from
q
1
to q
0
.
PS
q
1
Consumers
gains
Producers
gains
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CS
Q
D
, Q
S
(output units)
Price
Supply
Demand
p
0
q
0
The gains from freely
trading the units from
q
1
to q
0
.
PS
q
1
Consumers
gains
Producers
gains
CS
Q
D
, Q
S
(output units)
Price
p
0
q
0
PS
q
1
Consumers
gains
Producers
gains
Any regulation that
causes the units
from q
1
to q
0
to be
not traded destroys
these gains. This
loss is the net cost
of the regulation.
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Tax
Revenue
Q
D
, Q
S
(output units)
Price
q
0
PS
q
1
An excise tax imposed at a rate of Pt
per traded unit destroys these gains.
p
s
p
b
t
CS
Deadweight
Loss
Q
D
, Q
S
(output units)
Price
q
0
q
1
An excise tax imposed at a rate of Pt
per traded unit destroys these gains.
p
f
CS
Deadweight
Loss
So does a floor
price set at p
f
PS
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Q
D
, Q
S
(output units)
Price
q
0
q
1
An excise tax imposed at a rate of Pt
per traded unit destroys these gains.
p
c
Deadweight
Loss
So does a floor
price set at p
f
,
a ceiling price set
at p
c
PS
CS
Q
D
, Q
S
(output units)
Price
q
0
q
1
An excise tax imposed at a rate of Pt
per traded unit destroys these gains.
p
c
Deadweight
Loss
So does a floor
price set at p
f
,
a ceiling price set
at p
c
, and a ration
scheme that
allows only q
1
units to be traded.
PS
p
e
CS
Revenue received by holders of ration coupons.
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Calculating Gains and Losses
Estimates of the demand functions for households or
representative households would enable us to
calculate the impact of policy changes on each
household in terms of equivalent or compensating
variation.
This sort of analysis would therefore enable us to
address distributional issues, ie., the question of who
gains and who losses from the proposal.