Lecture 12 - Compensating and Equivalent variation in income Flashcards
What does compensating variation look at?
Compensating variation: How much money do we have to pay someone after a price increase to bring him/her back to their original utility level after the price of a good has increased?
On a preferences diagram, how can we identify the compensating variation?
On a preferences diagram we identify the compensating variation as the vertical difference between the consumer’s original point of consumption and their new point of consumption following the price increase
How do we find the compensating variation on a preferences diagram step by step?
1- Start with the optimal consumption point and label this A (indifference curve and budget constraint are tangential)
2- Find the consumption point after the price increase (Lower budget constraint is tangent to indifference curve)
3- Draw a higher budget constraint parallel to this lower one and is tangential to the original indifference curve to represent money paid to the consumer
4- Label this point C
5- The compensating variation is the vertical distance BC
What does equivalent variation look at?
Equivalent variation: Given a consumer’s choice before a price increase, how much money would we have to take away from that consumer to reduce her/his utility by as much as the price increase?
How do we find the equivalent variation on a preferences diagram?
1- Find the optimal point of consumption and label this point A
2- Draw a new budget constraint parallel to the original one and both tangential to the lower indifference curve and lower than the original budget constraint to represent money being taken away from the consumer
3- The equivalent variation is equal to the vertical difference between the two budget constraints
What is compensating and equivalent variation measured in?
They are both measured in pounds, £
What do demand curves reflect?
Demand curves reflect a consumer’s marginal valuation of a good
How does a consumer’s marginal valuation of a good change as more units of it are consumed?
- Marginal valuation declines as more units are consumed
- This means that for a consumer to keep consuming more units of the good the price of the good needs to keep falling with each purchase till it reaches zero
How do we calculate a consumer’s total valuation of a good from their demand curve?
Since total valuation is the sum of the marginal valuations, the total valuation can be calculated by the area under the demand curve from the first to last unit
What is consumer surplus?
The difference between the price paid and what the consumer would be willing to pay is called consumer surplus or Marshallian surplus
On a supply and demand diagram what area is consumer surplus given by?
Consumer surplus is given by the area below the demand curve and above the price
What is market consumer surplus?
- Market consumer surplus is the sum of the consumer surplus of all individual consumers
- This is because the market demand curve is the horizontal sum of all individual demand curves
What area is the market consumer surplus given by?
Market consumer surplus is given by the area below the market demand curve and above the price
Does consumer surplus change when the equilibrium price changes?
Yes
How do we calculate the consumer surplus at the equilibrium price given the market supply and demand functions?
1- Make the supply and demand functions equal and solve for the equilibrium price p
2- Plug this value of p back into the supply or demand function to get the equilibrium quantity
3- Find the inverse supply and demand functions by making P the subject of both
4- Plot these on a supply and demand diagram making sure they cross at the equilibrium values just worked out
5- Find the consumer surplus from the area of the triangle
