Professor Jay Bhattacharya Spring 2001

Motivation for Welfare Analysis • Is the consumer better off?

• In the last class, we found that the
Consumer Price Index (CPI) overstates a
“true” cost-of-living. without defining a
“true” cost-of-living index.
• Suppose, H H
Initial situation:
New situation:
Is the consumer better off?
– To answer this question, we need to make use of our
utility framework.
– Given both old and new prices and income, we can
calculate the consumer’s demand for goods.
– Then we plug these back into the consumer’s utility
function (deriving the indirect utility function) and
p0 , I 0 Þ x0 compare.
– But utility is an ordinal measure, we want a cardinal
H H measure so that we can know how much better (or
p1 , I1 Þ x1 worse) off the consumer is.
– We want a “monetary” value of welfare.

Spring 2001 Econ 11--Lecture 8 1 Spring 2001 Econ 11--Lecture 8 2

Three measures of the change Compensating Variation in

in welfare Income (CV)
• Compensating Variation (CV) • Given a price change from p0 to p* what is
the minimum income needed to get to the
• Equivalent Variation (EV) original level of utility, U0, at the new prices
p *?
• Change in Consumer Surplus (∆CS)
• “How much must I compensate you to make
you as well off as you were before the price
change?”

Spring 2001 Econ 11--Lecture 8 3 Spring 2001 Econ 11--Lecture 8 4

Compensating Variation and

Compensating Variation in Income (CV)
X2
Expenditure Minimization
I1/P2 Budget constraint after utility is
restored to the original level.
• In the graph, CV = I1 – I0
• I1 is the minimum expenditure needed to
I0/P2 Budget constraint
after price change. reach utility U0 at prices p*:
Original
Utility Level – E(U0, p*)
Original budget • I0 is the minimum expenditure needed to
CV=I1-I0 constraint. reach utility U1 at prices p0
– E(U0, p0)

X1
Spring 2001 Econ 11--Lecture 8 5 Spring 2001 Econ 11--Lecture 8 6

Econ 11--Lecture 8 1
Professor Jay Bhattacharya Spring 2001

Expenditure Minimization Solution to Expenditure

• The expenditure minimization problem is Minimization
the dual to the utility maximization • The solution to the expenditure
problem: minimization problem are the Hicksian
min
x1 , x2 p1 x1 + p2 x2 (“compensated”) demand functions:
s.t . U 0 = U ( x1 , x2 )
x1 = D1Hicksian (U , p1 , p2 ) x2 = D2Hicksian (U , p1 , p2 )
• The Lagrangian for this problem is:
• Plugging these back into p1x1 + p2x2 gives
L = p1 x1 + p2 x2 − µ (U (x1 , x2 ) − U 0 ) the minimum expenditure function:
– E(U0, p1, p2)

Spring 2001 Econ 11--Lecture 8 7 Spring 2001 Econ 11--Lecture 8 8

Relation Between Minimum Expenditure Compensating Variation and

Function and Hicksian Demand Hicksian Demand
• You can use the Envelope Theorem to • CV is the area to the left of the Hicksian
prove that the Hicksian demand functions Demand Curve.
are partial derivatives of the minimum – Why? Recall that CV = E(U0, p*) - E(U0, p0)
expenditure function, E(U, p1, p2) and suppose only p1 changes.

x1 = D1Hicksian (U , p1 , p2 ) =
∂E (U , p1 , p2 ) p1*

( )
p1*
( )
∂E U 0 , p1 , p2
ò D1 U , p1 , p2 dp1 = ò dp1 =
Hicksian 0
∂p1 p10 p10
∂p1
∂E (U , p1 , p2 ) ( ) ( )
x2 = D2Hicksian (U , p1 , p2 ) = = E U 0 , p1* , p2 − E U 0 , p10 , p2 = CV
∂p2
Spring 2001 Econ 11--Lecture 8 9 Spring 2001 Econ 11--Lecture 8 10

p1
Equivalent Variation in Income
x1 = D1Hicksian (U 0 , p1 , p2 ) (EV)
p1* • EV is the maximum amount the consumer
would be willing to pay to avoid a price
CV
change.
p10 • Given a price change from p0 to p*, how
much extra/less income is required to reach
final utility, U1 at the original prices p0?

x1
Spring 2001 Econ 11--Lecture 8 11 Spring 2001 Econ 11--Lecture 8 12

Econ 11--Lecture 8 2
Professor Jay Bhattacharya Spring 2001

Equivalent Variation in Income (EV) Equivalent Variation in Income (CV)

x2
I0(U1)/P2 Budget constraint before
price change, but after • At old prices, “Equivalent Variation” is the
Final Utility
compensation to reach amount of income necessary to get to the
final utility level. new level of utility.
I1(U1)/P2 Level
Original • EV is also the area to the left of the
Utility Level
Original budget Hicksian Demand Curve.
constraint.
– How? It’s a different Hicksian Demand Curve!
The one associated with the new level of utility.
Budget constraint
after price change.

x1
Spring 2001 Econ 11--Lecture 8 13 Spring 2001 Econ 11--Lecture 8 14

p1 How do CV and EV differ?

• Area under different Hicksian demand
(
x1 = D1Hicksian U 0 , p1 , p2 ) curves.
CV = Ip1*p10K • When is one concept more useful than the
H I
other?
p1* – Los Angeles decides to build a new freeway
which cuts through a neighborhood. How
EV = Hp1*p10J much would the city have to pay the residents
p10 of this neighborhood to keep them as well off
J K
as they were before? CV

(
x1 = D1Hicksian U 1 , p1 , p2 ) – What is the most the residents would pay not to
have the freeway? EV
x1
Spring 2001 Econ 11--Lecture 8 15 Spring 2001 Econ 11--Lecture 8 16

Change in Consumer Surplus Change in Consumer Surplus

• More common way to examine changes in p1
consumer welfare.
– Why? We don’t observe Hicksian Demand curves.
• Consumer surplus (CS) is the area to the left of the p1*
Marshallian Demand Curve. x1 = D1Marshallian (I , p1 , p2 )
• Note: Sometimes CS is defined as the area under
the Marshallian Demand Curve, but not in this
class.
p10
• While CV and EV are exact measures of the
change in welfare, the change in CS is an
approximate measure that is only valid for
specialized preferences. x1
Spring 2001 Econ 11--Lecture 8 17 Spring 2001 Econ 11--Lecture 8 18

Econ 11--Lecture 8 3
Professor Jay Bhattacharya Spring 2001

Linear Approximation of CV Linear Approximation of CV

p1 CV =Area (a+b+c) – Area (c)
1
p1* ≈ ( p1∗ − p10 ) x10 − ( p1∗ − p10 )( x10 − x1∗ )
c 2
a é 1 ù
b = ( p1∗ − p10 ) ê x10 − ( x10 − x1∗ )ú
ë 2 û
p10

=
∆p1 0
2
[
x1 + x1* ]
*
x
1
0
x
1 x1
Spring 2001 Econ 11--Lecture 8 19 Spring 2001 Econ 11--Lecture 8 20

Relationship between ∆CS, CV, EV p1

(
x1 = D1Hicksian U 1 , p1 , p2 )
• The relationship between ∆CS, CV, and EV
depends upon whether the good is normal or (
x1 = D1Hicksian U 0 , p1 , p2 )
inferior.
• For a normal good, the Hicksian demand curve is p1*
steeper than the Marshallian demand curve. z
– Why? Income and substitution effects go in the same w
direction. v
p10 x1 = D1Marshallia n (I , p1 , p2 )
• For an inferior good, the Hicksian demand curve
is flatter than the Marshallian demand curve.
– Why? Income and substitution effects go in opposite
directions.
x1* x10
Spring 2001 Econ 11--Lecture 8 21 Spring 2001 Econ 11--Lecture 8 22

Relationship between ∆CS, CV, EV

• CV = Area (w + v + z)
– new prices, old utility
• ∆CS = Area (w+v)
– utility not held fixed, income fixed
• EV = Area (w)
– old prices, new utility
• For a price increase: CV > ∆CS > EV
• For a price decrease: CV < ∆CS < EV

Spring 2001 Econ 11--Lecture 8 23

Econ 11--Lecture 8 4