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Consumer Theory Advanced Class 3 EC111

Consumer Theory Advanced Class 3 EC111. Consumer Welfare. An important problem in welfare economics is to devise a monetary measure of the gains and losses that individuals experience when prices change

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Consumer Theory Advanced Class 3 EC111

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  1. Consumer Theory Advanced Class 3 EC111

  2. Consumer Welfare • An important problem in welfare economics is to devise a monetary measure of the gains and losses that individuals experience when prices change • This is important for economic policy because economic policy usually changes prices due to either taxes or subsidies • Eg., If we can devise a monetary measure that compensates individuals for policies that affect theirconsumption choices, we can both manage well-being and obtain political approval for policies that affect choice. • Think of green subsidies/levies

  3. The Consumer Surplus Concept • The area below the (Marshallian) demand curve and above the market price is called consumer surplus • the excess of the willingness to pay over the amount extracted at the prevailing market price • changes in consumer surplus often are taken to measure the consumer welfare effects of price changes

  4. surplus loss px1 px0 x1 x0 The Consumer Surplus Concept px When the price rises from px0 to px1, the consumer suffers a loss in surplus xc(px…U0) Quantity of x

  5. The Consumer Surplus Concept If we approximate the net utility gain area under (the reservation-price curve by) the corresponding area under the ordinary demand curve then we get the Consumer’s Surplus approximate measure of net utility gain from buying a good at a market price. But this is not necessarily the “ideal” measure of a change in well-being due to a change in price because utility changes as we move along the ordinary demand curve. What would a better measure look like?

  6. Another way to measure changes in Consumer Welfare • Two additional monetary measures of the total utility change caused by a price change are Compensating Variation and Equivalent Variation. Consider a price rise…

  7. Compensation Variation (CV) • The CV is how much money we would have to give the consumer after the price change to make him just as well off as he was before the price changed. The reference of the CV is the initial level of utility. Equivalent Variation (EV) (An alternative measure of the change in consumer welfare is the EV) • The EV is how much money would have to be taken away from the consumer before the price changed to leave him as well off as he would be after the price change. The reference of the EV is the final level of utility. • In another words: • the EV is the amount of money that the consumer will be willing to pay to avoid the price change • the CV is the amount of money that the consumer will require to accept the price change

  8. Compensating Variation (CV) • Suppose the price of commodity 1 rises. • Q: What is the smallest amount of additional income which, at the new prices, would just restore the consumer’s original utility level? • A: The Compensating Variation.

  9. Compensating Variation p1=p1’ p2 is fixed. x2 u1 x1

  10. Compensating Variation p1=p1’p1=p1” p2 is fixed. x2 u1 u2 x1

  11. Compensating Variation p1=p1’p1=p1” p2 is fixed. x2 u1 u2 x1

  12. Compensating Variation p1=p1’p1=p1” p2 is fixed. x2 u1 CV = m2 - m1. u2 x1

  13. Equivalent Variation • Suppose the price of commodity 1 rises. • Q: What is the smallest amount of additional income which, at the original prices, would just restore the consumer’s new utility level? • A: The Equivalent Variation.

  14. Equivalent Variation p1=p1’ p2 is fixed. x2 u1 x1

  15. Equivalent Variation p1=p1’p1=p1” p2 is fixed. x2 u1 u2 x1

  16. Equivalent Variation p1=p1’p1=p1” p2 is fixed. x2 u1 u2 x1

  17. Equivalent Variation p1=p1’p1=p1” p2 is fixed. x2 u1 EV = m1 - m2. u2 x1

  18. Estimating the benefits from policy responses to GM foods in Europe Output Market Price Farm Income EV EU EUEU ($mill, 1997) EU NAM Baseline -0.90 -0.18 -1.08 249 2250 Adopt -0.18 -3.43 -3.61 1283 2173 Adopt, CAP 2.93 -3.14 -0.21 666 2172 Adopt, CAP -0.02 -0.06 -0.08 152 2205 social acc. low EU Ban 1.3 1.42 2.72 -1426 1767 Numbers are for coarse grains (maize, for example). Baseline assumes 5% productivity growth in maize only in North America (NAM). All numbers report percentage change from 1997 base year. Simulations are from general equilibrium model, specifying various functional forms (including utility functions) so that calculation of EV possible. Model calibrated to observed data.

  19. But what if we don’t want to make so many assumptions on functional forms? We can observe and measure “Consumer Surplus (CV)” because we can estimate ordinary demand and observe change in prices. Is this close to EV and CV?

  20. Some work has suggested that CS and CV are relatively close to each other (within 5%). So perhaps we can use CS as an approximation of CV without relying on all the assumptions necessary to actually calculate CV (such as the form of preferences).

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