Consumer Welfare and Policy Analysis - Lecture Notes | ECON 3020, Study notes of Microeconomics

Download Consumer Welfare and Policy Analysis - Lecture Notes | ECON 3020 and more Study notes Microeconomics in PDF only on Docsity! Page | 1 ECON 3020: INTERMEDIATE MICROECONOMICS HUSSAIN, FALL 2008 CHAPTER 5: CONSUMER WELFARE AND POLICY ANALYSIS This set of notes covers topics from Chapter 5 of the textbook, pages 130-167. You must read these notes in conjunction with relevant sections from Chapter 5. The main topics to be covered in this set of lecture notes include: (i) how do we measure consumer welfare and especially changes in consumer welfare; (ii) the compensating and equivalent measures of consumer welfare; and (iii) applying these measures to look at the effects of a government policy. MEASURING CONSUMER WELFARE: Economists and policy makers have always been and will always be interested to know how to compare changes in welfare across a broad group of consumers, such as how has a community of consumers been affected (better or worse off) as a result of a given government action or regulation. Recall from previous chapters that the one of the most important building block of consumer theory is the utility function. But individual utility functions are not observable in the market and it is not possible to compare utility values (such as utils of satisfaction) across consumers. As a result we will introduce and discuss the following three measures of calculating changes in consumer welfare (all of which will show changes in consumers’ welfare measured in dollars): • Consumer surplus • Compensating variation • Equivalent variation As long as we can somehow estimate a demand curve for the particular good in question we can calculate the above measures of surplus. But keep in mind that by saying a demand curve can be estimated we are implicitly assuming that: • Consumers’ preferences are well behaved – follows all the assumptions we talked about in Chapter 3. • When preferences are well behaved they can be translated to a well defined utility function. The indifference curves ensure that we can solve the constrained utility maximization problem and solve for the above demand curve for the product. Page | 2 CONSUMER SURPLUS: Welfare or surplus is the additional amount of satisfaction or benefit a consumer obtains from consuming (a unit of) a good over and above the cost of purchasing that (unit of the) good. In other words, if you are buying a unit of a good at a price which is lower than the benefit you derive from that unit you are better off buying the unit of the good. Your true willingness-to-pay (referred to as WTP ) is more than the actual price you pay in the market. Consumer surplus is a dollar measure of the sum of the per unit surpluses from zero unit of the good to the number of units bought at the market equilibrium price. An individual’s consumer surplus is measured by the area under the inverse demand curve and above the market price from zero units to the number of units the consumer buys. COMPENSATING AND EQUIVALENT VARIATION: Consider a situation where a consumer (Joe) is at his equilibrium – the tangency between his indifference curve and the budget constraint. Now consider an increase in price of one of the goods that Joe is buying. • Compensating variation is the amount of money that is needed to fully compensate for Joe’s loss in utility arising from the price increase. In other words, this is amount of money needed to keep Joe fixed at his previous indifference curve. • Equivalent variation is the amount of income that could be taken from Joe to leave him or her equally worse off as the price increase. In other words, this is amount of money needed to keep Joe fixed at his new indifference curve. • Both these measures are calculating how better or worse off Joe is after the price increase. The important difference between the two is that compensating variation is calculated at the original utility level and equivalent variation is calculated at the new utility level.