17.01.

26, 13:12 Preferences, Constraints and Consumer Choice

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CHAPTER 2 / PREFERENCES,
PREFERENCES,
PREFERENCES, CONSTRAINTS
CONSTRAINTS
CONSTRAINTS AND
AND
AND CONSUMER
CONSUMER
CONSUMER CHOICE
CHOICE
CHOICE

2.4 Consumer Welfare and Surplus

In the previous section, we saw that when income or the price of a good changes, the consumer’s optimal
choice shifts from one indifference curve to another, causing a change in welfare whose direction is obvious:
the consumer is better off if income increases or a price decreases, worse off if income decreases or a price
increases. However, establishing whether the consumer is better or worse off without also measuring this
change in welfare is not enough, nor does it make sense to do so using utility as a unit of measurement, since
utility is a purely ordinal concept. For consumer theory to be useful not only in explaining behavior but also
in comparing different market structures or assessing the social impact of a new technology or government
intervention, what we need is to measure in monetary terms the changes in welfare.

To understand why, suppose the government expects an inevitable future increase in food prices, for
example due to a pest damaging crops, and wants to prepare to give families a subsidy or bonus (effectively,
an increase in income) that ensures them a level of welfare equal to the current one. What should the
amount of the bonus be? And if the government could instead avoid the price increase, for example through
a pest control campaign, how much would families be willing to pay (i.e., how much income they would be
willing to give up, paying it to the government as taxes) to finance the campaign?

It should be clear that to answer questions like these, and many others, it is necessary to have a monetary
measure of welfare changes caused by changes in income or the price of a good. In the case of an income
change, we already have what we need, since the variation is already expressed in euros. And in the case of a
price change, how do we proceed? The idea is that every change in welfare caused by a price change can be
offset by an appropriate change in income. Being able to calculate this latter, we can then use it as a
monetary measure of the welfare change caused by the price variation.

Consumer Surplus
Chapter111 we introduced the concept of consumer surplus and accepted the idea of using the change in
In Chapter
Chapter
surplus caused by a price change as a monetary measure of the corresponding change in consumer welfare.

In the second part of this section, we will provide a foundation for that idea. In particular, we will show that
the change in surplus lies halfway between (and thus provides a reasonable approximation to) two exact
monetary measures of welfare change called compensating variation and equivalent variation.

Before doing this, let us review the concept of consumer surplus, assuming preferences represented by the
utility function U (X, Y ) = XY . In the previous
previous
previoussection
section
section we saw that in this case the optimal choice is to
spend half of the income, which we assume to be M = 360, on each of the two goods. The demand
function for good X is therefore X = 180/PX . ​

Housing (tens of m2 ) FIGURE 2.14

20

P X = 36
​

The income of the consu

B A The price of housing (go
10.00 Copyright (c) Alfredo Di Tillio

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17.01.26, 13:12 Preferences, Constraints and Consumer Choice

If the price of consumpt

the optimal choice is bu
corresponding to point A
Consumption (kg) in the bottom graph.
5.00 10.00 20.00

If the price of consumpt

euro/kg the optimal choice beco
B graph, corresponding to
36
function in the bottom g

The surplus of the consu

of euros equal to the red
ΔCS < 0
ΔCS

A
9
X = 180/PX ​

5.00 20
Consumption (kg)

Compensating Variation and Equivalent Variation

Continuing our example, suppose income is M = 360 and initially prices are PX = 9 and PY = 18. The ​ ​

optimal choice is then the bundle A = (20, 10), which yields utility U (20, 10) = 200. Now suppose the
price of good X increases to PX = 36. The optimal choice becomes bundle B = (5, 10), which yields
​

utility U (5, 10) = 50.

We can think of two ways to measure exactly and in monetary terms the consumer’s loss of welfare:

Compensating Variation (CV ): the additional income (subsidy) that would allow the consumer
to reach, at the new prices PX = 36 and PY = 18, the utility level of the old bundle A, i.e., U =
​ ​

200.

Equivalent Variation (EV ): the reduction in income (tax) that, at the old prices PX = 9 and ​

PY = 18, would bring the consumer to the utility level of the new bundle B , i.e., U = 50.
​

The following figure illustrates the calculation of compensating and equivalent variations and shows their
relation with the change in consumer surplus.

Housing (tens of m2 ) FIGURE 2.15

Show only optimal cho

Compute compensatin
20 Compute equivalent va

A
10
B

Consumption (kg)
5 10 20 40

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17.01.26, 13:12 Preferences, Constraints and Consumer Choice
euro/kg

B
36 ΔCS = −249.53 = −red area

A
9
X = 180/PX ​

5 20
Consumption (kg)

PREVIOUS: BUDGET
BUDGET
BUDGET CONSTRAINT,
CONSTRAINT,
CONSTRAINT, OPTIMAL
OPTIMAL
OPTIMAL CHOICE
CHOICE
CHOICE AND
AND
AND DEMAND
DEMAND
DEMAND

[END OF CHAPTER]

NEXT CHAPTER: PRODUCTION,

PRODUCTION,
PRODUCTION, COSTS
COSTS
COSTS AND
AND
AND FIRM
FIRM
FIRM CHOICE
CHOICE
CHOICE

Copyright (c) Alfredo Di Tillio

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