5 - Consumer Surplus, Compensating and Equivalent Variations

5
Consumer Surplus,
Compensating and
Equivalent Variations
Topics
• Consumer surplus. Welfare changes and
Marshallian demand curve.
• Consumer welfare and expenditure
function.
• Compensated demand curve.
• Compensating and equivalent variations.
Reading
 [В, гл 14],
 [ЧФ, гл 4],
 [К, гл 4, 4.6],
 [ДР, гл 4, п.4.3.1]
Change in Welfare
• An important problem in welfare economics
is to devise a monetary measure of the gains
and losses that individuals experience when
prices change
Three measures of the change in
welfare
• Change in Consumer Surplus (ΔCS)
• Compensating Variation (CV)
• Equivalent Variation (EV)
First we will describe the concept of consumer’s

surplus
Reservation price
• Suppose good 𝑥 can be bought only in

lumps of one unit (i.e. only available in
integer amounts).
• Use 𝑟1 to denote the most a single
consumer would pay for a 1st unit - call
this her reservation price for the 1st
unit.
• 𝑟1 is the dollar equivalent of the marginal
utility of the 1st unit.
Monetary Value of Consumer’s Gains
• Now that she has one unit of good, use 𝑟2 to

denote the most she would pay for a 2nd
unit - this is her reservation price for the
2nd unit.
• 𝑟2 is the dollar equivalent of the marginal
utility of the 2nd unit.
• Generally, if she already has 𝑛 − 1 units of

good then 𝑟𝑛 denotes the most she will pay
for an 𝑛th unit.
• 𝑟𝑛 is the dollar equivalent of the marginal
utility of the 𝑛th unit.
• 𝑟1 + ⋯ + 𝑟𝑛 will therefore be the dollar

equivalent of the total change to utility from
acquiring 𝑛 units of good at a price of $0.
• So 𝑟1 + ⋯ + 𝑟𝑛 − 𝑝𝑥 𝑛 will be the dollar
equivalent of the total change to utility from
acquiring 𝑛 units of good at a price of $𝑝𝑥
each.
• A plot of 𝑟1 + 𝑟2 + ⋯ + 𝑟𝑛 … against 𝑛 is a
reservation-price curve. This is not quite
the same as the consumer’s demand curve
for good 𝑥.
Reservation
price Reservation Price Curve for 𝑥-good
10𝑟1
8𝑟2
6𝑟3
4𝑟4
2𝑟5
0𝑟6
1 2 3 4 5 6 Quantity
• What is the monetary value of our

consumer’s gains in the 𝑥 -good market at a
price of $𝑝𝑥 ?
• The dollar equivalent net utility gain for the

1st unit is $(𝑟1 − 𝑝𝑥 )
• and is $(𝑟2 − 𝑝𝑥 ) for the 2nd unit,
• and so on, so the dollar value of the gain-to-
trade is
$(𝑟1 − 𝑝𝑥 ) + $(𝑟1 − 𝑝𝑥 ) + …
for as long as 𝑟𝑛 − 𝑝𝑥 > 0.
Reservation Reservation Price Curve for 𝑥-good

price
10𝑟1
8𝑟2
6𝑟3
4𝑟4 𝑝𝑥
2𝑟5
0𝑟6

price
𝑟1
10
𝑟8
2
𝑟6
3
𝑟4
4
𝑝𝑥
𝑟2
5
𝑟0
6
Reservation Price Curve for 𝑥-good
Reservation
price
𝑟1
10 Monetary value of net utility
𝑟8
2
gains-to-trade
𝑟6
3
𝑟4
4
𝑝𝑥
𝑟2
5
𝑟0
6
• Now suppose that good is sold in half-units.

• 𝑟1 + 𝑟2 + ⋯ + 𝑟𝑛 … denote the consumer’s
reservation prices for successive half-units
of good.
• Our consumer’s new reservation price curve
is
Reservation
𝑟1
10
𝑟38
𝑟56
𝑟74
𝑟92
𝑟11
0
1 2 3 4 5 6 7 8 9 10 11 Quantity, half-unit
Reservation
𝑟1
10
𝑟38
𝑟56
𝑟74
𝑟92 𝑝𝑥
𝑟11
0
Reservation
price
10
𝑟1 Reservation Price Curve for 𝑥-good
𝑟8
3
Monetary value of net
utility gains-to-trade
𝑟6
5
𝑟47
𝑝𝑥
𝑟2
9
𝑟11
0
• And if 𝑥-good is available in one-quarter

units ...
Reservation
10
8
6
4
2
0
1 2 3 4 5 6 7 8 9 10 11 Quantity,
one-quarter unit
Reservation
price
10
8
6
4 𝑝𝑥
2
0
1 2 3 4 5 6 7 8 9 10 11 Quantity,
one-quarter unit

price
10 Monetary value of net
8 utility gains-to-trade
6
4
𝑝𝑥
2
0
1 2 3 4 5 6 7 8 9 10 11 Quantity,
one-quarter unit
• Finally, if good can be purchased in any

quantity then ...
Reservation
price
Reservation
price
𝑝𝑥
𝒙
price
Monetary value of net utility gains-to-trade
𝑝𝑥
𝒙
• Unfortunately, estimating a consumer’s

reservation-price curve is difficult,
• so, as an approximation, the reservation-
price curve is replaced with the consumer’s
ordinary demand curve.
Consumer’s Surplus
• A consumer’s reservation-price curve is
not quite the same as her ordinary
demand curve. Why not?
• A reservation-price curve describes
sequentially the values of successive
single units of a commodity.
• An ordinary demand curve describes the
most that would be paid for 𝑞 units of a
commodity purchased simultaneously.
• Approximating the net utility gain area

under the reservation-price curve by the
corresponding area under the ordinary
demand curve gives the Consumer’s Surplus
measure of net utility gain.
Reservation price curve for 𝑥-good
𝒑
Ordinary demand curve for 𝑥-good
𝒙
𝒑
𝑝𝑥
𝒙
𝒑
𝑝𝑥
𝒙
𝒑
𝑝𝑥
𝒙
𝒑
𝑝𝑥
𝒙
• The difference between the consumer’s
reservation-price and ordinary demand
curves is due to income effects.
• But, if the consumer’s utility function is
quasilinear in income then there are no
income effects and Consumer’s Surplus is
an exact monetary measure of gains-to-
trade.
The consumer’s utility function is
quasilinear in 𝑥2
𝑈 𝑥1 , 𝑥2 = 𝑣 𝑥1 + 𝑥2
Take 𝑝ҧ2 = 1. Then the consumer’s
choice problem is to maximize
𝑈 𝑥1 , 𝑥2 = 𝑣 𝑥1 + 𝑥2
subject to
𝑝1 𝑥1 + 𝑝2 𝑥2 = 𝑚
That is, choose 𝑥1 to maximize
𝑣 𝑥1 + 𝑚 − 𝑝1 𝑥1
The first-order condition is

𝑣 ′ 𝑥1 − 𝑝1 = 0
That is,
𝑝1 = 𝑣 ′ 𝑥1
This is the equation of the consumer’s
ordinary demand for commodity 1.
𝑝1 Ordinary demand curve, 𝑝1 = 𝑣 ′ 𝑥1
CS
𝑝1′
𝑥1′ 𝑥1
𝑥1′
𝐶𝑆 = න 𝑣 ′ 𝑥1 𝑑𝑥1 − 𝑝1′ 𝑥1′

0
CS
p𝑝'11′
𝑥
x1
′' 𝑥1
1
𝑥1′
𝐶𝑆 = න 𝑣 ′ 𝑥1 𝑑𝑥1 − 𝑝1′ 𝑥1′ =

0
= 𝑣 𝑥1′ − 𝑣 0 − 𝑝1′ 𝑥1′
CS
p𝑝'11′
𝑥
x1
′' 𝑥1
1
𝑥1′
𝐶𝑆 = න 𝑣 ′ 𝑥1 𝑑𝑥1 − 𝑝1′ 𝑥1′ =

0
= 𝑣 𝑥1′ − 𝑣 0 − 𝑝1′ 𝑥1′
CS is exactly the consumer’s utility
gain from consuming 𝑥1′
p𝑝'11′ units of commodity 1.
𝑥
x1
′' 𝑥1
1
• Consumer’s Surplus is an exact dollar

measure of utility gained from consuming
commodity 1 when the consumer’s utility
function is quasilinear in commodity 2.
• Otherwise Consumer’s Surplus is an
approximation.
• The change to a consumer’s total utility due

to a change to 𝑝1 is approximately the
change in her Consumer’s Surplus.
𝑝1
𝑝1 𝑥1 , the inverse ordinary demand

curve for commodity 1
𝑝1′
𝑥1′
x𝑥*11
𝑝1
𝑝1 𝑥1
CS before
𝑝1′
𝑥1′
x𝑥*11
𝑝1
𝑝1 𝑥1
"′′
CS after
p𝑝11
p𝑝'11′
𝑥1′′ 𝑥1′'
x1 x𝑥*11
𝑝1
𝑝1 𝑥1 , inverse ordinary demand

curve for commodity 1.
p𝑝"11′′
Lost CS
p𝑝'11′
′′
𝑥1′'
𝑥1"
x1 x1 x𝑥*11
𝑥1
*
x1 Consumer’s Surplus
𝑥1∗ (𝑝1 ), the consumer’s ordinary
𝑥1′ demand curve for commodity 1.
𝑝1′′
∗
∆𝐶𝑆 = න 𝑥1 (𝑝1 )𝑑𝑝1
𝑥1′′
𝑝1′
Lost
measures the loss in
CS
Consumer’s Surplus.
𝑝1′ 𝑝1′′" 𝑝1
x1 x'1
Three measures of the change in
welfare
• Change in Consumer Surplus (Δ𝐶𝑆)
• Compensating Variation (𝐶𝑉)
• Equivalent Variation (𝐸𝑉)
Now we will describe the concepts of CV and EV

How to measure a person's “welfare”?
Let price vector is 𝐩 = (𝑝1 , 𝑝2 )

The target level of utility, the highest
attainable level of utility 𝑈(𝑥1 , 𝑥2 ) =
ഥ=𝑣
𝑈
Indirect utility function is 𝑉(𝐩, 𝑚)
Expenditure function is 𝐸(𝐩, 𝜐)
The two aspects of the problem
Primal: Max utility subject to Dual: Min cost subject to a utility
the budget constraint constraint
𝑉(𝐩, 𝑚) 𝐸(𝐩, 𝜐)
x2 x2
DE
DV
 
∗
x* 𝐱
x1 x1
What effect on max-utility of an increase What effect on min-expenditure of an increase in
in budget? target utility?
The problem…
Take the consumer's equilibrium and
x2 allow a price to fall…
u'
u .
Obviously the person is better off.
...but how much better off?
x** How do we quantify this gap?



x*
x1
Approaches to valuing utility change
 Three things that are not much use:

1. 𝒗′ − 𝒗 depends on the units of the U function
2. 𝒗′ /𝒗 depends on the origin of the U function
3. 𝒅(𝒗′ , 𝒗) depends on the cardinalisation of the U func.
 A more productive idea:

1. Use income not utility as a measuring rod
2. To do the transformation we use the V function
3. We can do this in (at least) two ways...
Version 1
• Suppose 𝐩 is the original price vector and 𝐩′ is
vector after good 1 becomes cheaper.
• This causes utility to rise from 𝑣 to 𝑣 ′
– 𝑣 = 𝑉(𝐩, 𝑚)
– 𝑣 ′ = 𝑉(𝐩′ , 𝑚)
• Express this rise in money terms?
– What hypothetical change in income would bring the
person back to the starting point?
– (and is this the right question to ask...?)
• Gives us a standard definition ….
In this version we get the
Compensating Variation
𝒗 = 𝑉(𝐩, 𝑚) the original utility level at

prices p and income m
𝒗 = 𝑉(𝐩′ , 𝑚 − 𝐶𝑉) the original utility level

restored at new prices p'
The amount CV is just sufficient to

“undo” the effect of going from 𝐩 to 𝐩′ .
• Letting CV denote this change in the consumer’s
income that would leave him as well off after the
price change as he was before, we have
𝑉 𝐩′ , 𝑚 − 𝐶𝑉 = 𝑉(𝐩, 𝑚)
• Note that, CV would be non-positive because 𝑉 is
non-increasing in 𝐩, increasing in m, and ↓𝑝1 :
𝑉 𝐩′ , 𝑚 + 𝐶𝑉 = 𝑉(𝐩, 𝑚)
• In our example CV is non-negative for ↑𝑝1 .
• This change in income, CV, required to keep a
consumer’s utility constant as a result of a price
change, is called the compensating variation, and
it was originally suggested by Hicks.
The fall in price of good 1
x2
The original utility level is the
u reference point.
Note that CV measured in

terms of good 2
CV
x**

 New
x* Original price
prices
x1
• The CV gives us a clear and interpretable
measure of welfare change.
• It values the change in terms of money (or
goods).
• But the approach is based on one specific
reference point.
• The assumption that the “right” thing to do
is to use the original utility level.
• There are alternative assumptions we might
reasonably make. For instance...
Version 2
• Again:
– 𝐩 is the original price vector
– 𝐩′ is the price vector after good 1
becomes cheaper.
• This again causes utility to rise from 𝑣 to 𝑣′.
• But now, ask ourselves a different question:
– Suppose the price fall had never happened
– What hypothetical change in income would
have been needed …
– …to bring the person to the new utility level?
In this version we get the Equivalent
Variation
𝒗′ = 𝑉(𝐩′, 𝑚) the utility level at new

prices p' and income m
𝑣 ′ = 𝑉(𝐩, 𝑚 + 𝐸𝑉) the new utility level

reached at original prices p
The amount EV is just sufficient to “mimic” the

effect of going from 𝐩 to 𝐩′.
Equivalent Variation
• EV is the way to measure the impact of a price
change in monetary terms before the price change
to leave him as well off as he would be after the
price change.
• It measures the maximum amount of income that
the consumer would be willing to pay to avoid the
price change.
Price fall is as before.
x2
u' The new utility level is now the
reference point
EV EV measured in terms of
good 2
x**

 New
x*
Original price
prices
x1
CV and EV...
• Both definitions have used the indirect utility
function.
– But this may not be the most intuitive approach
– So look for another standard tool..
• As we have seen there is a close relationship
between the functions 𝑉 and 𝐸.
• So we can reinterpret 𝐶𝑉 and 𝐸𝑉 using 𝐸.
• The result will be a welfare measure
– the change in cost of hitting a welfare level.
Remember:
consumer’s expenditure decreases mean welfare increases
Welfare change as – D(expenditure)
Compensating Variation as (–) change in cost of hitting
–D(expenditure): utility level 𝑣. If positive we
have a welfare increase.
𝐶𝑉 𝐩 → 𝐩′ = 𝐸 𝐩, 𝑣 − 𝐸(𝐩′, 𝑣)
Equivalent Variation as (–) change in cost of hitting

–D(expenditure): utility level 𝑣′. If positive we
have a welfare increase.
𝐸𝑉 𝐩 → 𝐩′ = 𝐸 𝐩, 𝑣 ′ − 𝐸(𝐩′, 𝑣′)
Using the above definitions we Looking at welfare change in

also have the reverse direction,
starting at p' and moving to
𝐶𝑉 𝐩′ → 𝐩 = 𝐸 𝐩′ , 𝑣 ′ − p.
𝐸(𝐩, 𝑣′)=−𝐸𝑉(𝐩 → 𝐩′)
Another (alternative) form for CV
 Use the expenditure-difference definition
𝐶𝑉 𝐩 → 𝐩′ = 𝐸 𝐩, 𝑣 − 𝐸(𝐩′, 𝑣)
 Assume that the price of good 1 changes from 𝑝1 to

𝑝1′ while other prices remain unchanged. Then we
can rewrite the above as:
𝑝1
𝜕𝐸1 𝐩, 𝑣
𝐶𝑉 𝐩 → 𝐩′ =න 𝑑𝑝1
𝑝1′ 𝜕𝑝1
It's using Shephard’s lemma:
the derivative of the
 Further rewrite as: expenditure function with
𝑝1 respect to p1 is the
𝐶𝑉 𝐩 → 𝐩′ = න ℎ1 𝐩, 𝑣 𝑑𝑝1 compensated demand function
𝑝1′
So CV can be seen as an area under the compensated demand curve
Compensated demand and the value of
a price fall
compensated (Hicksian)  Исходное равновесие
𝑝1
demand curve  снижение цены: (рост
благосостояния)
ℎ1 𝐩, 𝑣  оценка снижения цены
The CV provides an exact
относительно исходного
уровня полезности
welfare measure.
initial
price But it’s not the only
level
approach
Compensating
Variation
x*1
x1
Compensated demand and the value of
a price fall (2)
compensated (Hicksian)  … но отправной точкой
𝑝1 demand curve является новый уровень
полезности
The EV provides
 снижение цены: (рост
благосостояния)
ℎ1 𝐩, 𝑣 ′ another exact
welfare measure.
But based on a
different reference
point
Equivalent
Variation Other possibilities…
x**
1
x1
Ordinary demand and the value of a
price fall
ordinary (Marshallian)  Исходное равновесие
𝑝1
demand curve  снижение цены: (рост
 priceблагосостояния)
fall: (welfare increase)
ΔCS provides an
𝑑1 (𝐩, 𝑚) approximate welfare
measure.
Δ Consumer's
surplus
x*1 x**1
x1
Three ways of measuring the benefits of
a price fall
𝑝1
𝑑1 (𝐩, 𝑚)
ℎ1 𝐩, 𝑣 So, for normal goods:
ℎ1 𝐩, 𝑣 ′ 𝑪𝑽 < Δ𝑪𝑺 < 𝑬𝑽
 For inferior goods :

𝑪𝑽 > Δ𝑪𝑺 > 𝑬𝑽
𝑪𝑽 ≤ D𝑪𝑺 D𝑪𝑺 ≤ 𝑬𝑽
x*1 x**1
x1
CV and EV: Varian’s interpretation
• Price changes → ?
• The change in income necessary to restore
the consumer to his original indifference
curve is called the compensating variation
in income, since it is the change in income
that will just compensate the consumer for
the price change.
• The income change that is equivalent to the
price change in terms of the change in utility
is called the equivalent variation in income
• Suppose 𝑝1 rises.
• What is the least extra income that, at the
new prices, just restores the consumer’s
original utility level 𝑢1?
• The Compensating Variation
x2 𝑝1 = 𝑝1′ 𝑝2 = 𝑐𝑜𝑛𝑠𝑡
𝑚1 = 𝑝1′ 𝑥1′ + 𝑝2′ 𝑥2′
𝑥2′
𝑢1
𝑥1′ x1
𝑝1 = 𝑝1′′
𝑚1 = 𝑝1′ 𝑥1′ + 𝑝2 𝑥2′
𝑥2′′ = 𝑝1′′ 𝑥1′′ + 𝑝2 𝑥2′′
𝑥2′
𝑢1
𝑢2
𝑥1′′ 𝑥1′ x1
𝑝1 = 𝑝1′ 𝑝2 = 𝑐𝑜𝑛𝑠𝑡
x2 𝑝1 = 𝑝1′′
'"
𝑚1 = 𝑝1′ 𝑥1′ + 𝑝2 𝑥2′
𝑥x2′′′
2 = 𝑝1′′ 𝑥1′′ + 𝑝2 𝑥2′′
𝑥2′′ ′′ ′′′ ′′′
𝑥2′
𝑚2 = 𝑝1 𝑥1 + 𝑝2 𝑥2
𝑢1
𝑢2
𝑥1′′ 𝑥1′′′ 𝑥1′ x1
x2 𝑝1 = 𝑝1′′
'"
𝑚1 = 𝑝1′ 𝑥1′ + 𝑝2 𝑥2′
𝑥x2′′′
2 = 𝑝1′′ 𝑥1′′ + 𝑝2 𝑥2′′
𝑥2′′ ′′ ′′′ ′′′
𝑥2′
𝑚2 = 𝑝1 𝑥1 + 𝑝2 𝑥2
𝑢1
𝑢2 𝐶𝑉 = 𝑚2 − 𝑚1
𝑥1′′ 𝑥1′′′ 𝑥1′ x1
• Suppose 𝑝1 rises.
• What is the least extra income that, at the
original prices, just restores the consumer’s
original utility level?
• The Equivalent Variation.
𝑚1 = 𝑝1′ 𝑥1′ + 𝑝2′ 𝑥2′
𝑥2′
𝑢1
𝑥1′ x1
𝑝1 = 𝑝1′′
𝑚1 = 𝑝1′ 𝑥1′ + 𝑝2 𝑥2′
𝑥2′′ = 𝑝1′′ 𝑥1′′ + 𝑝2 𝑥2′′
𝑥2′
𝑢1
𝑢2
𝑥1′′ 𝑥1′ x1
x2 𝑝1 = 𝑝1′′
𝑚1 = 𝑝1′ 𝑥1′ + 𝑝2 𝑥2′
= 𝑝1′′ 𝑥1′′ + 𝑝2 𝑥2′′
𝑥2′′ ′ ′′′ ′′′
𝑥2′
𝑚2 = 𝑝1 𝑥1 + 𝑝2 𝑥2
'" 𝑢1
𝑥x2′′′
2
𝑢2
𝑥1′′ 𝑥1′′′ 𝑥1′ x1
x2 𝑝1 = 𝑝1′′
𝑚1 = 𝑝1′ 𝑥1′ + 𝑝2 𝑥2′
= 𝑝1′′ 𝑥1′′ + 𝑝2 𝑥2′′
𝑥2′′ ′ ′′′ ′′′
𝑥2′
𝑚2 = 𝑝1 𝑥1 + 𝑝2 𝑥2
'" 𝑢1
𝑥x2′′′
2
𝑢2 𝐸𝑉 = 𝑚1 − 𝑚2
𝑥1′′ 𝑥1′′′ 𝑥1′ x1
CV and EV
x2
CV
𝑝1 𝑝1′ 𝑝1′′
𝑝2 = 𝑐𝑜𝑛𝑠𝑡
EV
𝑥2′′
𝑥2′
u’
u”
𝑥1′′ 𝑥1′
x1
CV and EV
x2
EV
𝑝1 𝑝1′ 𝑝1′′
𝑝2 = 𝑐𝑜𝑛𝑠𝑡
CV
𝑥2′
𝑥2′′
u”
u’
𝑥1′ 𝑥1′′
x1
CV and EV
𝐶𝑉 𝐩 → 𝐩′ = −𝐸𝑉 (𝐩′ → 𝐩)
and visa versa

CV and EV: Example
0,5 0,5
Varian, ch 14 (14.8): 𝑈 𝑥1 , 𝑥2 = 𝑥1 𝑥2 .
Budget constraints are 𝑥1 + 𝑥2 = 100. Then 𝑝1
rises and now equals 2.
Calculate CV and EV.
Solution:
′ 𝑚 ′ 𝑚
𝑥1 = = 50; 𝑥2 = = 50
2𝑝1 2𝑥2
After 𝑝1 change we have (𝑥1′′ , 𝑥2′′ ) = (25,50)
CV and EV: Example
To calculate 𝐶𝑉 we ask how much money would be

necessary at prices (2,1) to make the consumer as
well off as he was consuming the bundle (50,50)?
If the prices were (2,1) and the consumer had
income m, we can substitute into the demand
functions to find that the consumer would
optimally choose the bundle(𝑚/4, 𝑚/2). Setting
the utility of this bundle equal to the utility of the
bundle (50, 50) we have
(𝑚෥ Τ4)0,5 (𝑚/2)
෥ 0,5
= 500,5 500,5 = 50
CV and EV: Example
Solving for m gives us

𝑚෥ = 100 2 ≈ 141,42
Hence the consumer would need about 141,42 −
100 = 41,42 of additional money after the price
change to make him as well off as he was before
the price change:
𝐶𝑉 ≈ 41,42
In order to calculate 𝐸𝑉 we ask how much money
would be necessary at the prices (1,1) to make the
consumer as well off as he would be consuming
the bundle (25,50).
CV and EV: Example
Letting 𝑚ෝ stand for this amount of money and

following the same logic as before,
(𝑚ෝ Τ2)0,5 (𝑚/2)
ෝ 0,5 = 250,5 500,5 = 25 2
Solving for m gives us

𝑚ෝ = 50 2 ≈ 70,71
Thus if the consumer had an income of 70 at the
original prices, he would be just as well off as he
would be facing the new prices and having an
income of 100.
The equivalent variation in income is therefore about
𝐸𝑉 ≈ 100 − 70,71 = 29,29
CV and EV: Example
Letting 𝑚ෝ stand for this amount of money and

following the same logic as before,
(𝑚ෝ Τ2)0,5 (𝑚/2)
ෝ 0,5
= 250,5 500,5
Solving for 𝑚ෝ gives us
𝑚
ෝ = 50 2 ≈ 70,71
Thus if the consumer had an income of 70 at the
original prices, he would be just as well off as he
would be facing the new prices and having an
income of 100.
The equivalent variation in income is therefore about
𝐸𝑉 ≈ 100 − 70,71 = 29,29
CV and EV: Example
Now we will calculate 𝐶𝑉 and 𝐸𝑉 (and 𝛥𝐶𝑆) using

another approach based on duality.
We remember
′
𝑚 50
𝑥1 = =
2𝑝1 𝑝1
Then the associated change in consumer’s surplus
when 𝑝1 changes from 1 to 2 is
2
50
∆𝐶𝑆 = න 𝑑𝑝1 ≈ 34,657
𝑝1
1
CV and EV: Example
Now we will calculate 𝐶𝑉 and 𝐸𝑉 (and 𝛥𝐶𝑆) using

another approach based on duality.
We remember
′
𝑚 50
𝑥1 = =
2𝑝1 𝑝1
Then the associated change in consumer’s surplus
when 𝑝1 changes from 1 to 2 is
2
50
∆𝐶𝑆 = න 𝑑𝑝1 ≈ 34,657
𝑝1
1
CV and EV: Example
Compensated (Hicksian) demand functions are

ഥ 𝑝2
𝑈 ഥ 𝑝1
𝑈
ℎ1 = and ℎ2 =
𝑝1 𝑝2
Expenditure function is
𝐸 = 2𝑈ഥ 𝑝1 𝑝2 = 2𝑣 𝑝1 𝑝2
Then
𝐶𝑉 = 𝐸 𝐩, 𝑣 − 𝐸 𝐩′ , 𝑣 𝐸𝑉 = 𝐸 𝐩, 𝑣 ′ − 𝐸 𝐩′ , 𝑣 ′
= 2 ∙ 50 1 ∙ 1 − 2 = 2 ∙ 25 2 1 − 2
∙ 50 2 ∙ 1 = ∙ 25 2 2 =
100 − 100 2 ≈ −41,42 50 2 − 100 ≈ 29,29
CV and EV: Example
Or
2 2
50
𝐶𝑉 = න ℎ1 𝐩, 𝑣 𝑑𝑝1 = න 𝑑𝑝1 ≈ 41,42
1 1 𝑝1
2 2
′
25 2
𝐸𝑉 = න ℎ1 𝐩, 𝑣 𝑑𝑝1 = න 𝑑𝑝1 ≈ 29,29
1 1 𝑝1

5 - Consumer Surplus, Compensating and Equivalent Variations

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

5 - Consumer Surplus, Compensating and Equivalent Variations

Uploaded by

Copyright:

Available Formats

5

First we will describe the concept of consumer’s

• Suppose good 𝑥 can be bought only in

• Now that she has one unit of good, use 𝑟2 to

• Generally, if she already has 𝑛 − 1 units of

• 𝑟1 + ⋯ + 𝑟𝑛 will therefore be the dollar

• What is the monetary value of our

• The dollar equivalent net utility gain for the

Reservation Reservation Price Curve for 𝑥-good

Reservation Reservation Price Curve for 𝑥-good

• Now suppose that good is sold in half-units.

• And if 𝑥-good is available in one-quarter

Reservation Reservation Price Curve for 𝑥-good

• Finally, if good can be purchased in any

Monetary value of net utility gains-to-trade

• Unfortunately, estimating a consumer’s

• Approximating the net utility gain area

The first-order condition is

𝐶𝑆 = න 𝑣 ′ 𝑥1 𝑑𝑥1 − 𝑝1′ 𝑥1′

𝐶𝑆 = න 𝑣 ′ 𝑥1 𝑑𝑥1 − 𝑝1′ 𝑥1′ =

𝐶𝑆 = න 𝑣 ′ 𝑥1 𝑑𝑥1 − 𝑝1′ 𝑥1′ =

• Consumer’s Surplus is an exact dollar

• The change to a consumer’s total utility due

𝑝1 𝑥1 , the inverse ordinary demand

𝑝1 𝑥1 , inverse ordinary demand

Now we will describe the concepts of CV and EV

Let price vector is 𝐩 = (𝑝1 , 𝑝2 )

x** How do we quantify this gap?

 Three things that are not much use:

 A more productive idea:

𝒗 = 𝑉(𝐩, 𝑚) the original utility level at

𝒗 = 𝑉(𝐩′ , 𝑚 − 𝐶𝑉) the original utility level

The amount CV is just sufficient to

Note that CV measured in

𝒗′ = 𝑉(𝐩′, 𝑚) the utility level at new

𝑣 ′ = 𝑉(𝐩, 𝑚 + 𝐸𝑉) the new utility level

The amount EV is just sufficient to “mimic” the

Equivalent Variation as (–) change in cost of hitting

Using the above definitions we Looking at welfare change in

 Assume that the price of good 1 changes from 𝑝1 to

 For inferior goods :

𝑚1 = 𝑝1′ 𝑥1′ + 𝑝2′ 𝑥2′

𝑚1 = 𝑝1′ 𝑥1′ + 𝑝2′ 𝑥2′

and visa versa

To calculate 𝐶𝑉 we ask how much money would be

Solving for m gives us

Letting 𝑚ෝ stand for this amount of money and

Solving for m gives us

Letting 𝑚ෝ stand for this amount of money and

Now we will calculate 𝐶𝑉 and 𝐸𝑉 (and 𝛥𝐶𝑆) using

Now we will calculate 𝐶𝑉 and 𝐸𝑉 (and 𝛥𝐶𝑆) using

Compensated (Hicksian) demand functions are

You might also like