Consumer Surplus

©1999 and 2006 by Peter Berck

Money Measures
‡ How much would you be willing to pay (WTP) for a new ski area? ‡ How much does it cost? ‡ Shouldn¶t build unless total WTP is greater than total cost. ‡ Need WTP in $. Need a money measure.

Overview
‡ ‡ ‡ ‡ TWTP and CS Relation of EV, CV and CS EV and CV for a publicly provided good Adding over consumers
± private good ± public good

Demand Curves
‡ Demand: Amount that will be purchased as a function of price p. ‡ (Inverse) Demand: Price consumers will pay for next unit as function of number of units consumed, q. ‡ P(Q) is willingness to pay for next unit

Demand Slopes Down
‡ willing to pay a lot more for the first pint of water (especially on a hot day in the desert) than for the pint after you have 40 gallons. ‡ wtp decreases as quantity increases

Total Willingness to Pay
‡ Total Willingness to pay is area under demand.
± demand price P(Q) is amount willing to pay for next unit ± So total willing to pay for Q units is P(1) + P(2) + ...+ P(Q)
‡ lower riemann sum and an approximation ‡ the area under the demand curve between 0 and Q units, which is the integral of demand, is (total) willingness to pay

Calculating Total Willingness
70 60 50
P ice

40 30 20 10 0 1 2 3 4
Quantity

AREA Demand

5

6

7

Consumer Surplus
‡ Consumer surplus is willingness to pay less amount paid ‡ Amount paid is P Q

Consumer surplus is willingness to pay less amount paid
‡ Willingness is blue + green. Surplus is just the green
p

D q

Willingness(Q)
The willingness to pay for q units is the blue area while the willingness to pay for q+n units is green and blue. Therefore the willingness to pay for n extra units is the green area p

D q q+n

Money Measures-Theory
‡ Think of projects as lowering prices.
± A new bridge lowers the price of crossing the bay by making one wait less time in toll plaza lines ± A new ski area lowers price by making the commute from LA to skiing be shorter

Lots of things
‡ can be thought of as price changes
± ipod mini brought price of carrying whole music library around from essentially infinity to $200. ± new dam reduces price of electricity (because there is more of it and demand curves slope down.)

‡ taxes, like environmental taxes, are price increases.

Surplus and Price
Price increases from p to p¶. CS was green+yellow+ orange. After increase it is only green. CS changes by the wedge that is yellow plus orange. p¶ P D q¶ q

CS is easy
‡ All you got to do is calculate an area. ‡ All you need is a demand curve ‡ Trouble is that CS is an approximate money measure ‡ Lets look at some exact money measures and see how compare

Exact money measures
‡ Equivalent Variation ‡ Compensating Variation ‡ For a normal good, consumer surplus is in between these two measures. (Willig¶s Theorem)

Equivalent Variation
‡ A consumer actually faces an increase in the price of a good from p0 to p1. ‡ That will make his utility go down from one indifference curve i to a lower indifference curve ii.

$ Equivalent
‡ If prices were left the same and instead money was taken away from the consumer
± How much money would you need to take away to reduce the consumers utility from i to ii? ± That amount of money is EV

EV Picture

Narrating the picture
‡ price doubled so now on new lower indifference curve ii. ‡ budget constraint III has original prices (parallel to budget constraint I) but is tangent to lower indiff curve ii. ‡ read change in income between I and III on the vertical axis (since the price of that good is 1).

EV
‡ The equivalent variation to a price change from p0 to p1 is the change in income that makes the consumer just as well off as if prices had changed from p0 to p1.

to remember EV..
‡ There are two equivalent ways to get the consumer to the new utility level:
± change income ± change prices

CV
‡ The co pensating variation to a price change from p0 to p1 is the change in income that leaves the consumer just as well off at price p1 as he would have been with his original income at p0.

CV Picture

narrate cv
‡ Start out on indifference curve i. The price increases. Now you are on curve ii. How much money needed to get back? ‡ Budget constraint III has the new prices and enough income to get back to old indifference curve.

CV
‡ The change in income compensates for the change in price. The consumer is no better or worse off than before.

Willig again
‡ for a price increase
± cv > CS > ev

‡ For the example in the textbook all three of these measures are within 63 cents and are on the order of $107. ‡ CS is more than good enough as a measure for a private good.

Publicly Provided Goods
‡ If the government provides a good and
± people have different preferences ± then some people won¶t get the amount they like

‡ People who can buy (or sell) a good all have the price as their wtp for the next unit of the good. ‡ Not true if government gives the good.

‡ Wolves in the yellowstone ecosystem
± some like em ± some don¶t ± some like em more than others ± everyone ³gets´ the same number²they are just out there²get over it.

Publicly Provided Good
35 30 i 25 ii

20 $

A

B

15

10 C 5

0 0 5 10 15 W olve s 20 25 30 35

EV and CV for Wolves
‡ Starting from point A, we calculate CV for 5 more wolves as follows. By adding 5 wolves, the consumer would be on indifference curve ii at point B. To return to indifference curve i, the consumer would need to give up $10 in income, so the CV is $10. For EV, the question is, how can we get the consumer back to indifference curve ii without providing wolves? The consumer can get from point A on i to point B on ii by adding 5 wolves, but even an infinite amount of income will not get her to ii, holding wolves constant; it will instead move her vertically along i. Hence EV is infinite.

Publicly provided conclusion
‡ If the indifference curves have are close to square shaped ‡ and the optimal amount (corners in this case) are not provided ‡ then ev and cv are very different.

WTP for Public Good
40 35 30 Tota l D e ma nd 25 20 15 10 5 0 0 10 W olve s 20 30 P e rson 1 's D e ma nd P e rson 2 's D e ma nd

The marginal willingness to pay for a public good is the vertical sum of the individuals¶ marginal willingness to pay values.

$