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**Chapter 14 Consumer’s Surplus**

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**Monetary Measures of Gains-to-Trade**

You can buy as much gasoline as you wish at $1 per gallon once you enter the gasoline market. Q: What is the most you would pay to enter the market? A: You would pay up to the dollar value of the gains-to-trade you would enjoy once in the market. How can such gains-to-trade be measured?

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**Monetary Measures of Gains-to-Trade**

Three such measures are: Consumer’s Surplus Equivalent Variation, and Compensating Variation. Only in one special circumstance do these three measures coincide.

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**Equivalent Utility Gains**

Suppose gasoline can be bought only in lumps of one gallon. Use r1 to denote the most a consumer would pay for a 1st gallon -- call this her reservation price for the 1st gallon. r1 is the dollar equivalent of the marginal utility of the 1st gallon.

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**Equivalent Utility Gains**

Now that she has one gallon, use r2 to denote the most she would pay for a 2nd gallon -- this is her reservation price for the 2nd gallon. r2 is the dollar equivalent of the marginal utility of the 2nd gallon.

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**Equivalent Utility Gains**

Generally, if she already has n-1 gallons of gasoline then rn denotes the most she will pay for an nth gallon. rn is the dollar equivalent of the marginal utility of the nth gallon.

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**Equivalent Utility Gains**

r1 + … + rn will therefore be the dollar equivalent of the total change to utility from acquiring n gallons of gasoline at a price of $0. So r1 + … + rn - pGn will be the dollar equivalent of the total change to utility from acquiring n gallons of gasoline at a price of $pG each.

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**Equivalent Utility Gains**

r1 r2 r3 r4 r5 r6 1 2 3 4 5 6

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**Equivalent Utility Gains**

What is the monetary value of our consumer’s gain-to-trading in the gasoline market at a price of $pG?

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**Equivalent Utility Gains**

The dollar equivalent net utility gain for the 1st gallon is $(r1 - pG) and is $(r2 - pG) for the 2nd gallon, and so on, so the dollar value of the gain-to-trade is $(r1 - pG) + $(r2 - pG) + … for as long as rn - pG > 0.

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**Equivalent Utility Gains**

$ value of net utility gains-to-trade r1 Consumer’s surplus or Net consumer’s surplus r2 r3 r4 pG r5 r6 1 2 3 4 5 6

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**Equivalent Utility Gains**

If gasoline can be purchased in any quantity then ...

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**Equivalent Utility Gains**

($) Res. Prices Reservation Price Curve for Gasoline $ value of net utility gains-to-trade pG Gasoline

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**Equivalent Utility Gains**

Unfortunately, estimating a consumer’s reservation-price curve is difficult, so, as an approximation, the reservation-price curve is replaced with the consumer’s ordinary demand curve. This approximation gives the Consumer’s Surplus measure of net utility gain.

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**Quasi-Linear Utility One special case would be quasi-linear utility.**

With quasi-linear utility, calculating CS using the reservation-price curve will result in the same value with that using the ordinary demand curve.

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**CS for Quasi-linear Utility**

p1 Ordinary demand curve, is exactly the consumer’s utility gain from consuming x1’ units of commodity 1. CS

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**Change in CS Now, what if there is a change in one of the prices?**

How would a price change affect the consumer’s surplus?

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Consumer’s Surplus p1 p1(x1), the inverse ordinary demand curve for commodity 1

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Consumer’s Surplus p1 p1(x1) CS before

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Consumer’s Surplus p1 p1(x1) CS after

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**Consumer’s Surplus p1 Lost CS p1(x1), inverse ordinary demand;**

x1*(p1), the consumer’s ordinary demand for commodity 1. Lost CS measures the loss in Consumer’s Surplus.

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**Compensating Variation and Equivalent Variation**

Two additional dollar measures of the total utility change caused by a price change are compensating variation (CV) and equivalent variation (EV).

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**Compensating Variation**

p1 rises. Q: What is the least extra income that, at the new prices, just restores the consumer’s original utility level?

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**Compensating Variation**

p1 rises. Q: What is the least extra income that, at the new prices, just restores the consumer’s original utility level? A: The Compensating Variation.

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**Compensating Variation**

x2 p1=p1’ p2 is fixed. u1 x1

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**Compensating Variation**

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

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**Compensating Variation**

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

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**Compensating Variation**

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

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**Equivalent Variation p1 rises.**

Q: How much money would have to be taken away from the consumer before the price change to leave him just as well off as he would be after the price change? A: The Equivalent Variation.

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

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

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

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

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CV and EV Both CV and EV measure “how far apart” two indifference curves are. Depend on the slope of the tangent line. CV does not equal EV in most cases. Only in quasilinear utility. Why? The distance of two indifference curves is the same no matter where it is measured. CV = EV = △ CS

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Producer’s Surplus Changes in a firm’s welfare can be measured in dollars much as for a consumer.

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Producer’s Surplus Output price (p) Supply Curve y (output units)

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Producer’s Surplus Output price (p) Supply Curve y (output units)

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**Producer’s Surplus y Output price (p) Producer’s Surplus. Supply Curve**

(output units)

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