Revealed Preferences, Consumer Surplus, Compensating and Equivalent Variation

Question 1

Describe the Principle of Revealed Preference

Answer 1

Let (x1,x2) be the chosen prices when prices are (p1,p2), and let (y1,y2) be some other bundle such that x1p1+x2p2 ≥ y1p1+y2p2. Then if the consumer is choosing the most preferred bundle that she can afford, we must have (x1,x2) ≻(y1,y2) ; Said simply, if a bundle x is chosen to a bundle y when both are affordable, then x must be preferred to y.

Question 2

How do we know that a bundle is indirectly revealed preferred to another bundle

Answer 2

(Slide 257): According to the assumption of transitivity, if bundle y is chosen over some bundle z, and bundle x is chosen over bundle y, then bundle x is revealed directly preferred to bundle z

Question 3

Define Consumer Surplus

Answer 3

Gives us a sense of welfare gains or losses to consumers from price changes, relevant for studying the effects of taxes, tariffs, farm subsidies, and a whole host of other policies affecting the prices of goods

Question 4

Where is Consumer Surplus found on a graph?

Answer 4

the area above the price and under the demand curve; at a given quantity we have the difference between WTP and the price actually paid

Question 5

Practice Consumer Surplus Slide 269-273
274

Answer 5

Remember to use inverse demand function because inverse demand = demand curve, and calculate

Question 6

Define Compensating Variation

Answer 6

the change in income that is needed to restore the consumer to their original indifference curve (new prices, old utility bundle)

Question 7

Define Equivalent Variation

Answer 7

Another way of measuring utility changes without using consumer surplus, we are finding how much the consumer would be willing to pay before the price change to maintain her original level of utility.

Question 8

Practice Compensating and Equivalent Variation problems 288-295

Answer 8

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