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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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