NORMATIVE ASPECTS: COMPENSATED AND EQUIVALENT

VARIATIONS
Changes in prices cause changes in the consumer´s welfare,
that, if consumer´s preferences are known, it is possible to
provide a monetary measure of the impact on their welfare
of that variations. We can use two alternative concepts:
Compensated Variation (CV) and Equivalent Variation (EV).

1. Compensated Variation, CV.

How much do we have to increase the consumer´s income
if we want their welfare to remain the same after an
increase in prices?
How much additional income is needed to compensate a
consumer for the increment of the “cost of living”?
- It would be necessary to give them enough income so
that, with the new prices, they could maintain the initial
satisfaction.
To calculate CV:
- Compensated Bundle (Initial satisfaction and final
prices).
- Compensated Income: 𝐼𝐶 = 𝑝𝑥1 . 𝑥𝐶 + 𝑝𝑦1 . 𝑦𝐶

- Compensated Variation. 𝐶𝑉 = 𝐼𝐶 − 𝐼0

2. Equivalent Variation, EV.

How much do we have to reduce the consumer´s income to
induce the same welfare loss as an increase in prices?
What is the income equivalent to the introduction of a tax
over the consumption of goods? For example, equivalence
between an income tax and a good price (affects its price).
- It would be necessary to give them enough income so
that, with initial prices, they could maintain the final
satisfaction.
To calculate the EV:
- Equivalent Bundle (final satisfaction and initial
prices).
- Equivalent Income: 𝐼𝐸 = 𝑝𝑥0 . 𝑥𝐸 + 𝑝𝑦0 . 𝑦𝐸

- Equivalent Variation. 𝐸𝑉 = 𝐼0 − 𝐼𝐸

Example: 𝒖(𝒙, 𝒚) = 𝒙. 𝒚; (𝒑𝟎𝒙 , 𝒑𝟎𝒚 ) = (𝟏, 𝟐); (𝒑𝟏𝒙 , 𝒑𝟏𝒚 ) =

(𝟑, 𝟑); 𝑰 = 𝟗𝟎. Calculate CV and EV.
Price Indices: Laspeyres Index
A price index compares a price vector for a period t, 𝑝𝑡 , with
the price vector of the base period, 𝑝0 . It provides a
summary statistics of the changes observed on a set of
prices, through an only figure.

A Laspeyres price index identifies the change in the cost of

a particular consumption bundle, 𝑞0 , between a base
period 0 and a period t:

∑𝑖 𝑝𝑖𝑡 . 𝑞𝑖𝑜
𝐿(𝑝𝑡 , 𝑝0 , 𝑞0 ) =
∑𝑖 𝑝𝑖𝑜 . 𝑞𝑖𝑜

Example: Calculate Laspeyres price index if (𝑝𝑥0 , 𝑝𝑦0 ) =

(1,2); (𝑝𝑥1 , 𝑝𝑦1 ) = (3,3); (𝑥0 , 𝑦0 ) = (45; 22,5).
Price Index: True price Index
A true price index shows the effect of the variation in prices
suffered by the consumer when the initial satisfaction level
is kept constant.
𝐼𝐶
𝐶𝑃𝐼𝑡𝑟𝑢𝑒 = 𝐼𝐶𝑉 =
𝐼0

Example: Use the same data to calculate a true price index.

Comparison between Laspeyres and true price indices.

The Laspeyres index overestimates the ideal index of the
cost of living because it assumes that consumers do not
react to price changes.
That is, it ignores that consumers will exploit the
possibilities of substitution between goods, buying more
(less) of the relatively cheaper (more expensive) goods.

CPI NOTES
The Spanish 𝐶𝑃𝐼𝑡 is obtained as a Laspeyres index:
𝑝𝑖𝑡 𝑔𝑖0 . 𝑝𝑖𝑡
𝐶𝑃𝐼𝑡 = 𝐿(𝑝𝑡 , 𝑝0 , 𝑤0 ) = ∑ 𝑤𝑖0 =∑
𝑖 𝑝 𝑖𝑜 𝑖 𝑔0 . 𝑝𝑖𝑜
𝑔𝑖0
where, 𝑤𝑖0 = is the share of total expenditure on good
𝑔0
i, 𝑔𝑖0 = 𝑝𝑖𝑜 . 𝑞𝑖0 is the expenditure on good i (for example,
in good x, 𝑝𝑥 . 𝑥) and 𝑔0 = ∑𝑖 𝑔𝑖0 = ∑𝑖 𝑝𝑖𝑜 . 𝑞𝑖0 . is the total
expenditure.
The weights 𝑤0 , are those of a “representative Spanish
household”. For its calculation, data from the EPF (Encuesta
de Presupuestos Familiares) is used. That is, for every good
or service, it would be estimated as the expenditure in a
good divided by the total expenditure in all goods for all
participant households in the sample.
o The calculation of the CPI usually presents an upward
bias (overestimates), part of it is due to the substitution
effect, but other causes may be in the aggregation system
of price samples and in the changes in the quality of the
goods.
o The method used in estimating the CPI and its use in
practice (e.g., to revise social security pensions or wages)
may have significant consequences on income distribution.
We can rewrite the Laspeyres formula as a weighted mean
of the CPI´s of the households in the EPF sample:
𝐶𝑃𝐼𝑡 = ∑ℎ 𝛼ℎ . 𝑐𝑝𝑖𝑡ℎ ,
where 𝑖𝑝𝑐𝑡ℎ is the Laspeyres index for each family and 𝛼ℎ is
its weight. Therefore, the CPI follows more closely the
consumption habits of the richer households in the sample
than those of the poorer households. For this reason, the
Laspeyres CPI is sometimes referred to as plutocratic index.
However, there is not difficulty in estimating a democratic
CPI; that is, an index in which every family has the same
weight:
𝑐𝑝𝑖𝑡ℎ
𝐷𝑡 = ∑ℎ (where H is the total amount of households of
𝐻
the sample).
The difference between these two indices, 𝐶𝑃𝐼𝑡 − 𝐷𝑡 ,
which is known as the plutocratic gap, has an interesting
interpretation: when it is positive, the prices of the goods
consumed more by the richer households (e.g., luxury
goods) increase more than those consumed more by
poorer households (e.g., normal or inferior goods), then the
plutocratic CPI overestimates the CPI of the poorer
households. Otherwise, the plutocratic gap is negative.
Aggregate demand curve (Market Demand)
Relates the aggregate demand of all consumers for a
certain good with its price.
It is the sum of the individual demand curves.

Example: there are three consumers that demand good x,

and have the same preferences represented by
𝑢ℎ = 𝑥 1/2 . 𝑦 1/2 , and, with incomes: 𝐼1 = 20; 𝐼2 =
100; 𝐼3 = 160. Calculate the aggregate demand of good x.
Consumer surplus
Measures the benefits the consumers derive from
participating in the market.
Consumer surplus: is the difference between a buyer’s
willingness to pay and the price they actually pay.

Therefore, the consumer surplus equals the area between

the demand curve and the market price (if the curve is
linear, CS is a triangle´s area).