Compensating & Equivalent Variation In Income

Question 1

How can we measure the welfare impact of price changes?

Answer 1

Compensating variation in income
Equivalent variation in income
Consumer surplus

Question 2

Can we simply compare the amounts of utility before and after a price change? Why/ why not?

Answer 2

No because we work with ordinal utility so numerical comparisons are meaningless

Question 3

What do we do if we can’t compare utility before and after due to ordinal utility?

Answer 3

Find measures that give us the monetary equivalent (£) of a utility change

Question 4

2 approaches that give a monetary equivalent of a utility change?

Answer 4

Compensating variation in income
Equivalent variation in income

Question 5

What is compensating variation?

Answer 5

How much money do we have to pay someone after a price increase to bring them back to their original utility level?

Question 6

Explain a compensating variation graph?

Question 7

What is equivalent variation?

Answer 7

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?

Question 8

In general what can we say about compensating and equivalent variation?

Answer 8

Compensating and equivalent variation of the same price change are different

Question 9

Explain how the two measures of utility change are based on different relative prices

Answer 9

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

Question 10

Consumer surplus is?

Answer 10

An alternative welfare measure to compensating and equivalent variation in income

Question 11

Demand curves reflect a consumer’s…?

Answer 11

A consumers marginal valuation of a good.

Question 12

How to see a consumers marginal valuation of a good?

Answer 12

Question 13

Total valuation of a given quantity consumed is?

Answer 13

The sum of marginal valuations

Question 14

For demand functions without steps what is the total valuation of a given Q consumed?

Answer 14

Area under the demand curve between the first and last units considered

Question 15

Where is consumer surplus?

Answer 15

The top triangle

Question 16

What is definition of consumer surplus?

Answer 16

Difference between price paid and what consumer is willing to pay

Question 17

What is market consumer surplus?

Answer 17

The sum of consumer surplus of all individual consumers

Question 18

Why is market consumer surplus the sum…consumers

Answer 18

Because market demand curve is the horizontal sum of all individual demand curves

Question 19

What is the issue of using consumer surplus ?

Answer 19

It’s only an approximate measure of consumer welfare

Question 20

Why is consumer surplus approximate?

Answer 20

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

Question 21

What is the marginal valuation argument?

Answer 21

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.

Question 22

When is the marginal valuation assumption a good assumption ?

Answer 22

If good A only accounts for a very small share of total expenditure

Question 23

How do we get the exact welfare change?

Answer 23

If we use compensated demand functions to calculate consumer surplus. We get exact welfare change.

Question 24

Why using compensated demand functions gives us exact welfare change?

Answer 24

Eliminated income effect by construction
Can compute consumer surplus as the area below the compensated demand curve and above price

Question 25

So why would we use consumer surplus based on uncompensated (Mashallian) demand curves at all?

Answer 25

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.

Question 26

Compensating and equivalent variations in income can measure what?

Answer 26

The welfare impact of price changes

Question 27

Demand curves can be used to derive what approximately?

Answer 27

Demand curves can derive approximate marginal valuation of goods

Question 28

The marginal valuation of goods helps us calculate what?

Answer 28

An alternative welfare measure of price change: consumer surplus

Question 29

When is consumer surplus only an exact measure of consumer welfare
Changes?

Answer 29

When based on compensated demand curves