EC201: Microeconomic Principles I

1.4 Consumer Theory: Price changes and welfare

What we have learned so far…

• In 1.1 - 1.3 we explored how to find uncompensated demand, compensated

demand and the expenditure function

• We also examined the income and substitution effects of a price change

(diagrammatically and using the Slutsky equation)

• We now examine the welfare effects of price changes more carefully

2
Price changes and welfare
1. Base weighted price indices
2. Substitution bias
3. The expenditure function price index
4. Change in Consumer Surplus (∆CS)
5. Compensating Variation (CV)
6. Equivalent Variation (EV)
7. Income effects and CV, EV and ∆CS
8. Using EV to assess the effects of a tax

3
1. Price indices measure inflation

• Public sector use

• Inflation targeting
• Adjusting levels of taxes, benefits, public pensions
• Indexed government bonds (gilts)
• Measurement of real wages

• Private sector use

• Pensions
• Price and wage setting
• Measurement of real wages

4
How to design price indices?

• Prices of different things change at different rates

• Price indices are weighted averages

• What should be included in the index? e.g. how about housing?

• What weights should be used?

5
UK price indices: CPI, CPIH and RPI
• Consumer Prices Index (CPI)
• Measures the change in the cost of a representative basket of goods and services bought
by households
• Interpreted as a measure of how the cost of the standard of living is changing.
• Official inflation target 2%

• Consumer Prices Index including owner occupiers’ housing costs (CPIH)

• Extends CPI to include a measure of the costs associated with owning, maintaining and
living in one’s own home - owner occupiers’ housing costs (OOH) - along with Council Tax.
• OOH costs and Council Tax are significant expenses for many households

• Retail Price Index (RPI)

• Measures the change in the cost of a representative sample of retail goods and services
• No longer classified as a ‘national statistic’ (since 2013)
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Contributions to CPI Inflation

Bank of England
Monetary Policy Report
August 2021
7
Current CPI inflation outlook
• The CPI rose by 3.2% in the 12 months to August 2021, up from 2.0% in July
• This is the largest ever recorded increase in the CPI 12-month inflation rate
series, which began in January 1997
• Inflation is above the 2% target. Why?
• Prices were low due to lockdowns and ‘Eat Out to Help Out’.
• As countries around the world have reopened, demand has increased sharply.
• Shortages of materials used in production have made it difficult to meet demand, pushing
up costs and prices.
• Above target inflation is expected to be temporary.
• Next report: November 2021.
8
Contributions to
CPIH 12-month
inflation rate

9
Base weighted price indices
• The CPI is a base weighted price index, or a Laspeyres price index

• Let 𝑥!" , 𝑥#" , 𝑥$" … 𝑥%" denote a (representative) consumption basket

of 𝑛 goods at date A

• Let 𝑝!" , 𝑝#" , 𝑝$" … 𝑝%" denote the prices of the goods at date A

• Let 𝑝!& , 𝑝#& , 𝑝$& … 𝑝%& denote the prices of the goods at date B

'!" (!# )'$" ($# )…)'%" (%#

• 𝐵𝑎𝑠𝑒 𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 =
'!# (!# )'$# ($# )…)'%# (%#

10
Base weighted price indices
!!" "!# #!$" "$# #…#!%" "%#
• 𝐵𝑎𝑠𝑒 𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 = !!# "!# #!$# "$# #…#!%# "%#

!!" "!# !$" "$# !%" "%#

= !!# "!# #!$# "$# #…#!%# "%#
+! + ⋯+ !
!# "!# #!$# "$# #…#!%# "%# !# "!# #!$# "$# #…#!%# "%#

&!# '!# &!" &$# '$# &$" &%# '%# &%"

= &!# '!# (&$# '$# (…(&%# '%# &!#
+
&!# '!# (&$# '$# (…(&%# '%# &$#
+⋯+
&!# '!# (&$# '$# (…(&%# '%# &%#

!!" !$" !%" !&# "&#

= 𝑤% ! +𝑤& ! + ⋯ + 𝑤' ! , where 𝑤( = !!# "!# #!$# "$# #…#!%# "%#
!# $# %#

• The base weighted price index is a weighted average of proportionate price increases,
where the weight for good i is the proportion of expenditure spent on good i at date A.
11
UK Millennials survey

12
How does spending vary with age? (ONS, 2017)
All

75+

65-74

50-64

30-49

less
than 30

0% 20% 40% 60% 80% 100%

Food and Non-Alcoholic Drinks Alcoholic Drinks, Tobacco and Narcotics Clothing and Footwear
Housing (net), Fuel and Power Household Goods and Services Health
Transport Communication Recreation and Culture
Education Restaurants and Hotels Miscellaneous Goodsand Services 13
National price indices are averages…

• So they may be poor measures of inflation for some people

• Expenditure weights are different for different people

• Price changes are different in different places

14
If income changes in line with
the base weighted price index,
then:
A. Consumers are neither better off nor
worse off
B. Consumers cannot be worse off, but
may be better off
C. Consumers cannot be better off, but
may be worse off
D. Consumers will definitely be better off

15
Let’s have a look…
• Suppose there are two consumer goods
'!" (!# )'$" ($#
• The base weighted price index:
'!# (!# )'$# ($#

• At prices 𝑝1𝐴, 𝑝2𝐴 , consumption (𝑥1𝐴, 𝑥2𝐴) is optimal and generates 𝑢𝐴;
income (and expenditure) is 𝑝!" 𝑥!" + 𝑝#" 𝑥#"

• Suppose prices change to 𝑝1𝐵, 𝑝2𝐵

• If income changes at the same rate as the base weighted priced index it
changes to 𝑝!& 𝑥!" + 𝑝#& 𝑥#"
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2. Substitution bias

• If income increases at the same rate as the base weighted price index,
then the consumer cannot be worse off

• If relative prices 𝑝1/𝑝2 change and substitution is possible then the

consumer is better off!

• Let’s see why…

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Can the consumer be worse off?
𝑥2

• Originally income 𝑚, prices

𝑝1𝐴, 𝑝2𝐴, and consumer
chooses (𝑥1𝐴 , 𝑥2𝐴)
𝐵𝐿𝐴
• 𝐵𝐿𝐴: 𝑝!" 𝑥!" + 𝑝#" 𝑥#" = 𝑚

𝐴
𝑥2𝐴 ●
– 𝑝1𝐴/𝑝2𝐴

0 𝑥1𝐴 𝑥1
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Can the consumer be worse off?
𝑥2

• Prices change to 𝑝1𝐵, 𝑝2𝐵 and 𝐵𝐿𝐵

income rises at the same rate
so is 𝑝!& 𝑥!" + 𝑝#& 𝑥#"
– 𝑝1𝐵 /𝑝2𝐵
𝐵𝐿𝐴
• 𝐵𝐿𝐵: 𝑝1𝐵 𝑥1𝐴 + 𝑝2𝐵𝑥2𝐴 = 𝑚

• Cannot be worse off as 𝐴

𝑥2𝐴 ●
– 𝑝1𝐴/𝑝2𝐴
(𝑥1𝐴 , 𝑥2𝐴) is still affordable!
0 𝑥1𝐴 𝑥1
19
Can the consumer be better off?
𝑥2
• The consumer substitutes and
𝐵𝐿𝐵
becomes better off
𝑢𝐴 𝑢𝐵
• A base-weighted price index
keeps the basket constant and
𝐵𝐿𝐴 ●𝐵
measures the change in its
cost…but consumers change 𝑥2𝐴 ●𝐴
their bundle when prices
0 𝑥1𝐴 𝑥1
change! Substitution bias
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Is the consumer necessarily better off?
𝑥2
𝑢𝐴
• Consider perfect complements
𝐵𝐿𝐵
• The consumer is better off only
if substitution is possible
𝐵𝐿𝐴

𝐴
𝑥2𝐴 ●

0 𝑥1𝐴 𝑥1
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What if all prices rise at the same rate?
𝑥2
• If prices change at the same
rate, then 𝐵𝐿𝐴 and 𝐵𝐿𝐵 are the
same

• Consumer no better or worse 𝐵𝐿𝐴 = 𝐵𝐿𝐵

off!

𝑥2𝐴 ●𝐴

0 𝑥1𝐴 𝑥1
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3. The expenditure function price index

• Recall: the expenditure function 𝐸(𝑝1, 𝑝2, 𝑢) is the minimum amount

of money you have to spend to get utility u with prices 𝑝1 and 𝑝2

𝐸 𝑝!& , 𝑝#& , 𝑢"

𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 =
𝐸 𝑝!" , 𝑝#" , 𝑢"

23
The expenditure function price index
𝑥2
• 𝐸(𝑝1𝐴, 𝑝2𝐴, 𝑢" ) is the minimum 𝐸 𝑝!" , 𝑝#" , 𝑢$
expenditure needed to get 𝐵𝐿𝐶 𝐸 𝑝!$ , 𝑝#$ , 𝑢$

utility 𝑢𝐴 at initial prices.

Budget line 𝐵𝐿𝐴.
𝐵𝐿𝐴 𝐶
●
• 𝐸(𝑝1𝐵, 𝑝2𝐵, 𝑢" ) is the minimum
𝑥2𝐴 ●𝐴
expenditure needed to get 𝑢𝐴
utility 𝑢𝐴 after prices change. 0 𝑥1𝐴 𝑥1
Budget line 𝐵𝐿𝐶 . 24
The expenditure function price index
𝑥2
• If income increases at the same 𝐸 𝑝!" , 𝑝#" , 𝑢$
rate as the expenditure function 𝐵𝐿𝐶 𝐸 𝑝!$ , 𝑝#$ , 𝑢$

price index, then the budget line

after the price and income
𝐵𝐿𝐴 𝐶
change change is 𝐵𝐿𝐶 ●

𝑥2𝐴 ●𝐴
• The consumer is no better off or 𝑢𝐴

worse off 0 𝑥1𝐴 𝑥1

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Base weighted vs expenditure function price indices
𝑥2 𝑚" 𝑝!" 𝑥!$ + 𝑝#" 𝑥#$
• Base weighted price index: =
𝑚$ 𝑝!$ 𝑥!$ + 𝑝#$ 𝑥#$
budget line 𝐵𝐿𝐵 𝐵𝐿𝐵

𝐵𝐿𝐶 𝑚% 𝐸 𝑝!" , 𝑝#" , 𝑢$

• Expenditure function price index: =
𝑚$ 𝐸 𝑝!$ , 𝑝#$ , 𝑢$
budget line 𝐵𝐿𝐶
𝐵𝐿𝐴 ●𝐵
• Income change needed for 𝐶●

𝐵𝐿𝐶 < income needed for 𝐵𝐿𝐵 𝑥2𝐴 ●𝐴 𝑢𝐵

𝑢𝐴
if substitution is possible
0 𝑥1𝐴 𝑥1
26
Problems with the CPI?
Substitution bias:
• If different prices change at very different rates, relative prices change a
lot and the substitution bias is larger
• CPI is thought to overstate inflation (and so understates real income)
• Statisticians producing CPI understand substitution bias; try to account
for it
New products:
• How do we introduce new products into price indices?

27
Problem with the expenditure function price index
• Requires knowledge of the expenditure function
• The expenditure function is derived from the utility function
• …but the utility function is unobservable!

How can we measure the impact of price changes on consumer’s

welfare in monetary terms?
• Compensating Variation and Equivalent Variation developed by Hicks,
and the relationship to consumer surplus.

28
4. Change in Consumer Surplus (∆CS)
• Consider an increase in price of good 1 from 𝑝1𝐴 to 𝑝1𝐵

• The consumer reoptimises but ends up with lower utility

• What if we wanted to compensate the consumer somehow? We need

a monetary measure of the impact of the price change

• One possibility is to compensate based on the fall in consumer surplus

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Change in Consumer Surplus
𝑥2 𝑝1
Indifference map Uncompensated Demand
𝑚/𝑝2 𝑢B 𝑢𝐴 𝑥1(𝑝1, 𝑝2, 𝑚)

𝑝!" ●𝐵 𝑢𝐵 here
𝐵 ●
●𝐴
𝑝!$ ●𝐴
𝑢𝐴 here

𝑝!" 𝑝!$
− −
𝑝# 𝑝#
0 𝑥1𝐵 𝑥1𝐴 𝑥1 𝑥1𝐴 𝑥1
0 𝑥1𝐵
30
5. Compensating Variation (CV)
• Consider an increase in price of good 1 from 𝑝1𝐴 to 𝑝1𝐵

• The price of good 2 is fixed at 𝑝#

• The compensating variation for a price increase from 𝑝1𝐴 to 𝑝1𝐵 is the
amount of extra money the consumer needs to receive in order to get
the same level of utility as before the price change

31
Compensating variation 𝐶𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑛𝑔 𝑣𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 =

𝑥2 𝐸 𝑝!& , 𝑝# , 𝑢" − 𝐸 𝑝!" , 𝑝# , 𝑢"

𝐸 𝑝!" , 𝑝#, 𝑢$
𝐶𝑉 𝑝#
𝑝#
𝐸 𝑝!$ , 𝑝#, 𝑢$
𝐵
𝑝# ●

𝑥2𝐴 ●𝐴 𝑝!$
𝑝!" 𝑢𝐴 − 𝑝
− #
𝑝#
0 𝑥1𝐴 𝑥1
32
CV and Shephards’ Lemma
• Recall Shephard’s Lemma (topic 1.3):

𝜕𝐸 𝑝1, 𝑝2, 𝑢
= ℎ1(𝑝1, 𝑝2, 𝑢)
𝜕𝑝1

• Recall the relationship between differentiation and integration

(see Appendix)

'')
C ℎ1(𝑝1, 𝑝2, 𝑢)𝑑𝑝! = 𝐸 𝑝1𝐵, 𝑝2, 𝑢 − 𝐸 𝑝1𝐴, 𝑝2, 𝑢
''(

33
Compensating variation

𝑝1 Compensating variation when 𝑝1

rises from 𝑝1𝐴 to 𝑝1𝐵
&!#

𝑝1𝐵 𝐵 =@ ℎ1(𝑝1, 𝑝2, 𝑢$ )𝑑𝑝!

● &!"
= 𝐸 𝑝!" , 𝑝#, 𝑢$ − 𝐸 𝑝!$ , 𝑝#, 𝑢$
𝑝1𝐴 ●𝐴

Compensated demand
curve ℎ1(𝑝1, 𝑝2, 𝑢$ )

0 𝑥1𝐵 𝑥1𝐴 𝑥1
34
6. Equivalent Variation (EV)
• Consider an increase in price of good 1 from 𝑝1𝐴 to 𝑝1𝐵

• The price of good 2 is fixed at 𝑝#

• The equivalent variation for a price increase from 𝑝1𝐴 to 𝑝1𝐵 is the amount
of money that needs to be taken away from the consumer (without
changing prices) that has the same effect on utility as the price change

35
Equivalent variation 𝐸𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑣𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 =

𝑥2 𝐸 𝑝!& , 𝑝# , 𝑢& − 𝐸 𝑝!" , 𝑝# , 𝑢&

𝐸 𝑝!" , 𝑝#, 𝑢"

𝐸𝑉 𝑝#
𝑝# 𝐸 𝑝!$ , 𝑝#, 𝑢" ●𝐵
𝐴
𝑝# ●
●𝐶
𝑢𝐴
𝑢𝐵
𝑝!" 𝑝!$
− −
𝑝# 𝑝#
0 𝑥1
36
Equivalent variation
Equivalent variation when 𝑝1
𝑝1 rises from 𝑝1𝐴 to 𝑝1𝐵

&!#
𝑝1𝐵 𝐵 =@ ℎ1(𝑝1, 𝑝2, 𝑢" )𝑑𝑝!
● &!"

𝑝1𝐴 = 𝐸 𝑝!" , 𝑝#, 𝑢" − 𝐸 𝑝!$ , 𝑝#, 𝑢"

●𝐶

Compensated demand
curve ℎ1(𝑝1, 𝑝2, 𝑢𝐵)

0 𝑥1𝐵 𝑥1𝐶 𝑥1
37
Let’s put it all together…
𝑥2 𝑝1
Indifference map Demand curves
𝐶𝑉
ℎ1(𝑝1, 𝑝2, 𝑢𝐵 )
𝑝#
ℎ1(𝑝1, 𝑝2, 𝑢𝐴)
𝐸𝑉
𝐵
𝑝# ●𝐵 𝑝!" ●𝐶 ●
●𝐶
𝐴
● 𝐷 𝐴
𝐷 𝑝!$ ● ●
●

𝑥1(𝑝1, 𝑝2, 𝑚)
𝑢𝐴
𝑢B
0 𝑥1𝐶 𝑥1𝐵 𝑥1𝐷 𝑥1𝐴 𝑥1 𝑥1𝐶 𝑥1𝐵 𝑥1𝐷 𝑥1𝐴 𝑥1
0 38
Compensating variation
𝑥2 𝑝1
Indifference map Demand curves
𝐶𝑉
ℎ1(𝑝1, 𝑝2, 𝑢𝐵 )
𝑝#
ℎ1(𝑝1, 𝑝2, 𝑢𝐴)
𝐸𝑉
𝐵
𝑝# ●𝐵 𝑝!" 𝐸 ●𝐶 ●
●𝐶 𝐶𝑉 = 𝐸𝐵𝐴𝐹

𝐴
● 𝐹 𝐷 𝐴
𝐷 𝑝!$ ● ●
●

𝑥1(𝑝1, 𝑝2, 𝑚)
𝑢𝐴
𝑢B
0 𝑥1𝐶 𝑥1𝐵 𝑥1𝐷 𝑥1𝐴 𝑥1 𝑥1𝐶 𝑥1𝐵 𝑥1𝐷 𝑥1𝐴 𝑥1
0 39
Equivalent variation
𝑥2 𝑝1
Indifference map Demand curves
𝐶𝑉
ℎ1(𝑝1, 𝑝2, 𝑢𝐵 )
𝑝#
ℎ1(𝑝1, 𝑝2, 𝑢𝐴)
𝐸𝑉
𝐵
𝑝# ●𝐵 𝑝!" 𝐸 ●𝐶 ●
●𝐶 𝐸𝑉 = 𝐸𝐶𝐷𝐹

𝐴
● 𝐹 𝐷 𝐴
𝐷 𝑝!$ ● ●
●

𝑥1(𝑝1, 𝑝2, 𝑚)
𝑢𝐴
𝑢B
0 𝑥1𝐶 𝑥1𝐵 𝑥1𝐷 𝑥1𝐴 𝑥1 𝑥1𝐶 𝑥1𝐵 𝑥1𝐷 𝑥1𝐴 𝑥1
0 40
Change in Consumer Surplus
𝑥2 𝑝1
Indifference map Demand curves
𝐶𝑉
ℎ1(𝑝1, 𝑝2, 𝑢𝐵 )
𝑝#
ℎ1(𝑝1, 𝑝2, 𝑢𝐴)
𝐸𝑉
𝐵
𝑝# ●𝐵 𝑝!" 𝐸 ●𝐶 ●
●𝐶 ∆𝐶𝑆 = 𝐸𝐶𝐴𝐹

𝐴
● 𝐹 𝐷 𝐴
𝐷 𝑝!$ ● ●
●

𝑥1(𝑝1, 𝑝2, 𝑚)
𝑢𝐴
𝑢B
0 𝑥1𝐶 𝑥1𝐵 𝑥1𝐷 𝑥1𝐴 𝑥1 𝑥1𝐶 𝑥1𝐵 𝑥1𝐷 𝑥1𝐴 𝑥1
0 41
Normal good: CV, EV and ∆CS
𝑝1
Demand curves
• Uncompensated demand is more ℎ1(𝑝1, 𝑝2, 𝑢𝐵 )
elastic than compensated demand ℎ1(𝑝1, 𝑝2, 𝑢𝐴)
because income and substitution 𝐵
effects work in the same direction 𝑝!" 𝐸 ●𝐶 ●

• For a price rise 𝐸𝑉 < ∆𝐶𝑆 < 𝐶𝑉

𝐹 𝐷 𝐴
𝑝!$ ● ●

𝑥1(𝑝1, 𝑝2, 𝑚)

𝑥1 𝑥1𝐶 𝑥1𝐵 𝑥1𝐷 𝑥1𝐴 𝑥1

0 42
7. Income effects and CV, EV and ∆CS
• A price rise of a normal good gives rise to 𝐸𝑉 < ∆𝐶𝑆 < 𝐶𝑉

• Why? The difference in EV and CV arises from the income effect

• EV is measured at a lower level of utility. Since good 1 is normal, less is

consumed at lower utility

• What if the good is inferior? 𝐶𝑉 < ∆𝐶𝑆 < 𝐸𝑉

• What if there is no income effect? 𝐶𝑉 = ∆𝐶𝑆 = 𝐸𝑉

43
Which monetary welfare measure should we use?

• If income effects are small (income elasticity of uncompensated demand

and/or the budget share are small), then CV, EV and ∆CS are close
• Can use change in CS as easy to measure

• If income effects are large, then

• CV to compensate for the price change
• EV for the monetary equivalent of the price change

44
Example: fuel tax
• A government imposes a fuel tax

• Fuel is a large share of expenditure so the income effect

is significant – ∆CS not a great approximation

• The government may need to compensate people for

the increase in tax – CV is relevant

• May want to know how different groups are affected

(e.g. pensioners, commuters etc) – EV is relevant

• Ecuador vs Nigeria - reduction of fuel subsidies

45
8. Using EV to assess the effects of a tax
• Excise tax on good 1 raises price from 𝑥2
𝑝!$ to 𝑝!$ + 𝑡, where 𝑡 is the tax

• A to B: uncompensated demand falls

from 𝑥!$ to 𝑥!" 𝑚
𝑝!
𝐸𝑉
• EV = monetary measure of loss to 𝐴
●𝐵
𝑝! 𝑝"#
consumer ● −
𝑝!
𝐶
●
0 𝑥1
𝑝"# + 𝑡
−
𝑝!
46
8. Using EV to assess the effects of a tax
• Budget constraint with tax:
𝑥2
(𝑝1𝐴 + 𝑡) 𝑥1𝐵 + 𝑝2𝑥2𝐵 = 𝑚

• Tax revenue (R) = 𝑡𝑥!&

𝑅
= 𝑚 − 𝑝1𝐴𝑥1𝐵 − 𝑝2𝑥2𝐵 𝑝!
𝐴
𝐸𝐵 ●𝐵 ● −
𝑝"#
𝑝! 𝑝!
• Excess burden of an excise tax
𝐶
= EV – tax revenue ●
= consumer losses – tax revenue 0 𝑥1
𝑝"# + 𝑡
−
𝑝!
47
Lump sum tax to raise revenue R?

𝑥2
• Lump sum tax of R:
𝑝1𝐴 𝑥1 + 𝑝2𝑥2 = 𝑚 − R

• A lump sum tax that raises the

same revenue as an excise tax 𝑡 𝑅
reduces utility by less (A to D) 𝑝!
𝐴
𝐸𝐵 ●𝐵 ● −
𝑝"#

●𝐷
𝑝! 𝑝!
• Politically sustainable? Ethical? 𝐶
●
0 𝑥1
𝑝"# + 𝑡
−
𝑝!
48
What have we achieved?
• Understanding of uses and limitations of price indices

• Monetary measures of the impact of price changes on consumer’s

welfare

• Application of these measures to taxes and subsidies (change in CS, EV

and CV)

• Insights on the effect of compensation on consumer demand

49
Review checklist:
1. What is a base-weighted price index? How is it computed? What
are its limitations?
2. What is substitution bias and when does it arise?
3. How does the CPI compare to the expenditure function price
index?
4. Define CV, EV and ∆CS.
5. Can you illustrate CV, EV and ∆CS for a price change in the case of a
normal good? How about for an inferior good?
6. How do CV, EV and ∆CS compare if there is no income effect?
7. What is the excess burden of an excise tax? Why does it arise?

50
Appendix 1 - differentiation and integration

51
The relationship between differentiation and integration

If y = f ( x ) y

dy f’(x)
= f ' ( x)
dx

b
0 a b x
then f(b) - f ( a ) = ò f ' ( x )dx
a

52
Appendix 2 - Derivation of the formula for the fall in
consumer surplus in terms of elasticity

53
How can we estimate ∆CS?
𝑝1
Uncompensated Demand
• Depends on price elasticity of demand
𝑥1(𝑝1, 𝑝2, 𝑚)

• If there are few substitutes then 𝑝!" ●𝐵 𝑢𝐵 here

demand is more inelastic so the fall in
consumer surplus is larger
𝑝!$ 𝐴
● 𝑢 here
𝐴
• If demand is more elastic the fall in
consumer surplus is smaller (to see
this graphically, pivot the demand
curve through A to make steeper or
shallower)
𝑥1 𝑥1𝐴 𝑥1
0 𝑥1𝐵
54
How can we estimate ∆CS?
𝑝1
Uncompensated Demand
• If demand is approximately linear, we
can estimate ∆CS using observable 𝑥1(𝑝1, 𝑝2, 𝑚)
prices and quantities
𝑝!" ●𝐵

• Fall in CS =
!
𝑝!" − 𝑝!$ 𝑥!$ − # 𝑝!" − 𝑝!$ 𝑥!$ − 𝑥!" 𝑝!$ 𝐴
●

𝑥1 𝑥1𝐴 𝑥1
0 𝑥1𝐵
55
How can we estimate ∆CS?
𝑝1
Uncompensated Demand
• If demand is approximately linear, 𝑥1(𝑝1, 𝑝2, 𝑚)
we can estimate ∆CS using
observable prices and quantities 𝑝!" ●𝐵

• Fall in CS =
1 𝑝!$ 𝐴
●
( p1B - p1 A ) x1 A - ( p1B - p1 A )( x1 A - x1B )
2
1
» Dp1 x1 A + Dp1Dx1
2
• This crucially depends on elasticity 𝑥1
0 𝑥1𝐵 𝑥1𝐴 𝑥1
56
How can we estimate ∆CS?
• Easy to estimate using the formula 𝑝1
Uncompensated Demand
𝑥1(𝑝1, 𝑝2, 𝑚)
• Fall in CS =
𝑝!" ●𝐵

𝑝!$ 𝐴
●

Increase in Own price Proportionate

the cost of elasticity of price increase
buying good 1 demand < 0
𝑥1 𝑥1𝐴 𝑥1
0 𝑥1𝐵
57
• Manipulating to express in terms of elasticity:

1
Dp1 x1 A + Dp1Dx1
2
æ 1 Dx1 ö æ 1 æ Dx1 p1 ö Dp1 ö
= Dp1 x1 A çç1 + ÷÷ = Dp1 x1 A ç1 + çç ÷÷ ÷
2 x ç 2 Dp x p ÷
è 1A ø è è 1 1A ø 1 ø
æ 1 Dp1 ö Dx1 p1
= Dp1 x1 A çç1 + e ÷÷ where e = < 0 = elasticity
è 2 p1 ø Dp1 x1 A
58