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

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15.03.2011 1 Chapter 5 Consumer Welfare and Policy Analysis The welfare of the people is the ultimate law. Cicero ECON201 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 ECON201 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.
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15.03.2011 2 ECON201 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 ECON201 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 ECON201 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.
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15.03.2011 3 ECON201 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 * : ECON201 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. ECON201 Spring 2011 5-9 5.2 Compensating Variation and Equivalent Variation Indifference curves can be used to determine compensating variation (CV) and equivalent variation (EV).
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