Chapter 05 - 15.03.2011 1 Chapter 5 Consumer Welfare and...

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Unformatted text preview: 15.03.2011 1 Chapter 5 Consumer Welfare and Policy Analysis The welfare of the people is the ultimate law. Cicero ECO N201 – Spring 2011 5-2 Chapter 5 Outline 5.1 Consumer Welfare 5.2 Expenditure Function and Consumer Welfare 5.3 Market Consumer Surplus 5.4 Effects of Government Policies on Consumer Welfare 5.5 Deriving Labor Supply Curves ECO N201 – Spring 2011 5-3 5.1 Consumer Welfare • How much are consumers helped or harmed by shocks that affect the equilibrium price and quantity? • Shocks may come from new inventions that reduce firm costs, natural disasters, or government-imposed taxes, subsidies, or quotas. • You might think utility is a natural measure of consumer welfare. Utility is problematic because: • we rarely know a consumer’s utility function • utility doesn’t allow for easy comparisons across consumers • A better measure of consumer welfare is in terms of dollars. 15.03.2011 2 ECO N201 – Spring 2011 5-4 5.1 Consumer Surplus • Consumer surplus (CS) is the monetary difference between the maximum amount that a consumer is willing to pay for the quantity purchased and what the good actually costs. • Step function ECO N201 – Spring 2011 5-5 5.1 Consumer Surplus • Consumer surplus (CS) is the area under the inverse demand curve and above the market price up to the quantity purchased by the consumer. • Smooth inverse demand function ECO N201 – Spring 2011 5-6 5.1 Effect of a Price Change on Consumer Surplus • If the price of a good rises (e.g. £0.50 to £1), purchasers of that good lose consumer surplus (falls by A + B ) • This is the amount of income we would have to give the consumer to offset the harm of an increase in price. 15.03.2011 3 ECO N201 – Spring 2011 5-7 5.2 Expenditure Function and Consumer Welfare • Offsetting the harm of a price increase means increasing income just enough to maintain the consumer’s utility. • Utility is not constant along an uncompensated demand curve. • More precise CS measure utilizes compensated demand and the expenditure function, which both do hold utility constant. • Recall that the minimal expenditure necessary to achieve a specific utility level and given a set of prices is: • Welfare change associated with price increase to p 1 * : ECO N201 – Spring 2011 5-8 5.2 Expenditure Function and Consumer Welfare • Which level of utility should be used in this calculation? • Two options: • Compensating variation is the amount of money we would have to give a consumer after a price increase to keep the consumer on their original indifference curve. • Equivalent variation is the amount of money we would have to take away from a consumer to harm the consumer as much as the price increase did....
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This note was uploaded on 03/22/2012 for the course ECON 201 taught by Professor Çakmak during the Fall '10 term at Middle East Technical University.

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Chapter 05 - 15.03.2011 1 Chapter 5 Consumer Welfare and...

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