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Consumer Surplus

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Monetary Measures of Gains-to- Trade Basic idea of consumer surplus: We want a measure of how much a person is willing to pay for something. Price measures marginal willingness to pay, so add up over all different outputs to get total willingness to pay.

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Monetary Measures of Gains-to- Trade You can buy as much gasoline as you wish at €p per liter once you enter the gasoline market. How can the gains-to-trade be measured?

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Suppose gasoline can be bought only in lumps of one liter. Use r 1 to denote the most a single consumer would pay for a 1st liter -- call this her reservation price for the 1st liter. r 1 is the euro equivalent of the marginal utility of the 1st liter. € Equivalent Utility Gains

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Now that she has one liter, use r 2 to denote the most she would pay for a 2nd liter -- this is her reservation price for the 2nd liter. r 2 is the euro equivalent of the marginal utility of the 2nd liter. € Equivalent Utility Gains

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Generally, if she already has n-1 liters of gasoline then r n denotes the most she will pay for an n-th liter. r n is the euro equivalent of the marginal utility of the n-th liter. € Equivalent Utility Gains

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So r 1 + … + r n - pn will be the euro equivalent of the total change to utility from acquiring n liters of gasoline at a price of €p each. € Equivalent Utility Gains

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12 345 6 r1r1 r2r2 r3r3 r4r4 r5r5 r6r6 p € value of net utility gains-to-trade

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Now suppose that gasoline is sold in half-liter units. r 1, r 2, …, r n, … denote the consumer’s reservation prices for successive half-liters of gasoline. € Equivalent Utility Gains

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1 2 34 56 r1r1 r3r3 r5r5 r7r7 r9r9 r 11 7 891011 p € value of net utility gains-to-trade

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And if gasoline is available in one- quarter liter units... € Equivalent Utility Gains

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p € value of net utility gains-to-trade

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Finally, if gasoline can be purchased in any quantity then... € Equivalent Utility Gains

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

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Unfortunately, estimating a consumer’s reservation-price curve is difficult, so, as an approximation, the reservation-price curve is replaced with the consumer’s demand curve. € Equivalent Utility Gains

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A consumer’s reservation-price curve is not quite the same as her demand curve. Why not? A reservation-price curve describes sequentially the values of successive single units of a commodity. A demand curve describes the most that would be paid for q units of a commodity purchased simultaneously. Consumer’s Surplus

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Approximating the net utility gain area under the reservation-price curve by the corresponding area under the demand curve gives the Consumer’s Surplus measure of net utility gain. Consumer’s Surplus

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The change to a consumer’s total utility due to a change to p 1 is approximately the change in her Consumer’s Surplus. Consumer’s Surplus

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p1p1 p 1 (x 1 ), the inverse demand curve for commodity 1

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Consumer’s Surplus p1p1 CS before p 1 (x 1 )

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Consumer’s Surplus p1p1 CS after p 1 (x 1 )

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Consumer’s Surplus p1p1 Lost CS p 1 (x 1 ), inverse demand curve for commodity 1

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Two additional euro measures of the total utility change caused by a price change are Compensating Variation and Equivalent Variation. Compensating Variation and Equivalent Variation

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p 1 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. Compensating Variation

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p 1 rises. Q: What is the least extra income that, at the original prices, just restores the consumer’s original utility level? A: The Equivalent Variation. Equivalent Variation

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In general, EV, CV and CS are different …, but the change in consumer's surplus is usually a good approximation. Consumer’s Surplus, Compensating Variation and Equivalent Variation

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

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Measuring Welfare Changes of Individuals Exact Utility Indicators –Equivalent Variation (EV) –Compensating Variation (CV) Relationship between Exact Utility.

Measuring Welfare Changes of Individuals Exact Utility Indicators –Equivalent Variation (EV) –Compensating Variation (CV) Relationship between Exact Utility.

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