Compensating & Equivalent Variation In Income Flashcards
How can we measure the welfare impact of price changes?
Compensating variation in income
Equivalent variation in income
Consumer surplus
Can we simply compare the amounts of utility before and after a price change? Why/ why not?
No because we work with ordinal utility so numerical comparisons are meaningless
What do we do if we can’t compare utility before and after due to ordinal utility?
Find measures that give us the monetary equivalent (£) of a utility change
2 approaches that give a monetary equivalent of a utility change?
Compensating variation in income
Equivalent variation in income
What is compensating variation?
How much money do we have to pay someone after a price increase to bring them back to their original utility level?
Explain a compensating variation graph?
What is equivalent variation?
Given a consumer’s choice before a price increase, how much money do we have to take away from them to reduce their utility by as much as the price increase?
In general what can we say about compensating and equivalent variation?
Compensating and equivalent variation of the same price change are different
Explain how the two measures of utility change are based on different relative prices
Compensating variation is how much money is required to compensate the consumer given the new prices
Equivalent variation is how much money needs to be taken away from the consumer given the old prices
Consumer surplus is?
An alternative welfare measure to compensating and equivalent variation in income
Demand curves reflect a consumer’s…?
A consumers marginal valuation of a good.
How to see a consumers marginal valuation of a good?
Total valuation of a given quantity consumed is?
The sum of marginal valuations
For demand functions without steps what is the total valuation of a given Q consumed?
Area under the demand curve between the first and last units considered
Where is consumer surplus?
The top triangle
What is definition of consumer surplus?
Difference between price paid and what consumer is willing to pay
What is market consumer surplus?
The sum of consumer surplus of all individual consumers
Why is market consumer surplus the sum…consumers
Because market demand curve is the horizontal sum of all individual demand curves
What is the issue of using consumer surplus ?
It’s only an approximate measure of consumer welfare
Why is consumer surplus approximate?
It ignores income effects (along the demand curve, income is held constant. So if we spend more on good A, we have less money for other goods)
Marginal valuation argument
What is the marginal valuation argument?
The marginal valuation argument assumes that utility from consuming A doesn’t depend on how much money is left for B (I.e on the consumers income)
If the marginal utility of an additional unit is higher than the price, individuals are likely to consume more because the perceived benefit outweighs the cost. On the other hand, if the marginal utility is lower than the price, individuals may choose to consume less.
When is the marginal valuation assumption a good assumption ?
If good A only accounts for a very small share of total expenditure
How do we get the exact welfare change?
If we use compensated demand functions to calculate consumer surplus. We get exact welfare change.
Why using compensated demand functions gives us exact welfare change?
Eliminated income effect by construction
Can compute consumer surplus as the area below the compensated demand curve and above price
So why would we use consumer surplus based on uncompensated (Mashallian) demand curves at all?
Because it can be difficult to measure income effects. For many goods income effects of price changes aren’t very important so consumer surplus derived from uncompensated demand curves are a good approximation.
Compensating and equivalent variations in income can measure what?
The welfare impact of price changes
Demand curves can be used to derive what approximately?
Demand curves can derive approximate marginal valuation of goods
The marginal valuation of goods helps us calculate what?
An alternative welfare measure of price change: consumer surplus
When is consumer surplus only an exact measure of consumer welfare
Changes?
When based on compensated demand curves
