Microeconomics
Lecture Note 8
Juyoung Cheong
Kyung Hee University
So far
I How changes in income and prices affect quantity consumed
I Price Effect=Substitution Effect + Income Effect
I Slutsky Equation
Welfare
I But sometimes we wonder how the well-being of a consumer is
affected by a price change
I You may think that we can look at how the consumer’s utility
changes, but
I utility numbers are only useful for comparison but have no
meaning
I utility numbers cannot be aggregated across people
Welfare
I Suppose the price of good x increases.
I How much does this price change hurt the consumer?
Two Ways of Translating Welfare into Money (1)
1. Compensating Variation (CV)
The amount of money we would need to give to the consumer
AFTER the price increase so that s/he is just as well off as
before the price increase
(Or: the money we can take away from the consumer after the
price decrease so that s/he is just as well off as before)
Two Ways of Translating Welfare into Money (2)
2. Equivalent Variation (EV)
The amount of money that can be taken away from the
consumer BEFORE the price increase so that s/he is just as well
off as after the price increase
(Or: the money we need to give to the consumer before the price
decrease so that s/he is just as well off as after)
Compensating Variation (Price Increase)
M0
U0
x
Compensating Variation (Price Increase)
M0
B A
U0
U1
x
Compensating Variation (Price Increase)
y
MC
CV
M0
B A
U0
U1
x
Equivalent Variation (Price Increase)
M0
B A
U0
U1
x
Equivalent Variation (Price Increase)
M0
EV
ME
B A
H
U0
U1
x
CV and EV: Numerical Example
Q: Junho consumes only two goods: x and y . His utility function is
given by
U(x, y ) = 2x + 2y .
Junho has an income of $200. The price of good y is $2. Suppose
the price of good x changes from $1 to $2.
1. Find the compensating variation (CV) and explain your
answer. Show the CV in a diagram
2. Find the equivalent variation (EV) and explain your answer.
Show the EV in a diagram
CV is the area left of the original Hicksian Demand
CV = M0 − MC
= e(A; U0 ) − e(H; U0 )
= e(Px0 , Py , U0 ) − e(Px1 , Py , U0 )
∂e(Px ,Py ,U0 )
I
∂Px = x h (Px , Py , U0 )
R Px1 ∂e(Px ,Py ,U0 ) R Px1
I
Px0 ∂Px dPx = Px0 x h (Px , Py , U0 )dPx
CV is the area left of the original Hicksian Demand
y
MC
CV
M0
H
B A
U1 U0
x
Px
D h (U0 )
P1
P0 Dm
x
xB xH xA
CV is the area left of the original Hicksian Demand
y
MC
CV
M0
H
B A
U1 U0
x
Px
D h (U0 )
P1
P0 Dm
x
xH xA
EV is the area left of the newl Hicksian Demand
EV = ME − M0
= e(H; U1 ) − e(B; U1 )
= e(Px0 , Py , U1 ) − e(Px1 , Py , U1 )
R Px1 ∂e(Px ,Py ,U1 ) R Px1
I
Px0 ∂Px dPx = Px0 x h (Px , Py , U1 )dPx
EV is the area left of the new Hicksian Demand
M0
EV
ME
B A
H U0
U1
x
Px
P1
P0 Dm
D h (U1 ) x
xB xH xA
EV is the area left of the new Hicksian Demand
M0
EV
ME
B A
H U0
U1
x
Px
P1
P0 Dm
D h (U1 ) x
xB xH xA
Area left of the Marshallian Demand is the change in
Consumer’s Surplus
Z Px1
∆CS = x m (Px , Py , M)dPx
Px0
Area left of the Marshallian Demand is the change in
Consumer’s Surplus
M0
B A
U1 U0
x
Px
P1
P0 Dm
x
xB xA
Area left of the Marshallian Demand is the change in
Consumer’s Surplus
M0
B A
U1 U0
x
Px
P1
P0 Dm
x
xB xA
CV, EV and Change in Consumer’s Surplus
Normal Good, Price Increase
Px
EV = S
D h (U0 ) ∆CS = S + T
P1 CV = S + T + U
U
S
T
P0
Dm
D h (U1 )
Qx
xB xA
CV, EV and Consumer’s Surplus
I The picture of CV, EV and the change in Consumer’s Surplus
may look somewhat different depending on
I whether the good is normal or inferior;
I whether it is a price increase or a price decrease
I Yet the change in Consumer’s Surplus is always between CV
and EV
I Thus Consumer’s Surplus is a handy approximation of welfare
change
I If the Hicksian and Marshallian demands are the same,
Consumer’s Surplus will be an exact measure of welfare (e.g.
Preferences are quasi-linear)
