Lecture 11: Consumer Surplus Outline 1.

Introduction

c 2009 Jerey A. Miron

2. Consumer Welfare from a Discrete Good under Quasilinear Preferences 3. Consumer Surplus 4. Compensating and Equivalent Variation 5. Cost-Benet Analysis

Introduction

Our analysis in the rst eight lectures aimed at understanding what choices a consumer would make when faced with a given set of prices and income. That is one question of interest in many contexts. In particular, it provides a positive analysis, meaning one that describes what actions the consumer will take. This is exactly what individuals, or rms, or policy makers might want to know in some circumstances. An additional question, however, concerns to what degree dierent prices or policies make a consumer better or worse o. We have already examined whether changes in the economic environment raise or lower consumer welfare whether the consumer ends up on a higher or lower indierence curve but we have not discussed any way to quantify these changes. In many circumstances, it is important to provide a magnitude, not just a direction, for the welfare implications. This lecture discusses several approaches to quantifying consumer welfare. Each is related to the others, and in practice they do not dier radically. They do dier conceptually, however, and it is useful to understand each approach and its limitations.

Consumer Welfare from a Discrete Good with Quasilinear Preferences

Consider rst the case where one good is discrete, meaning it can only be purchased in lumpy increments. For example, one can buy one car, or two cars, and so on, but not 30% of a car. Assume also that preferences are quasilinear. In particular, they are linear in some composite good that we can think of as money spent on all other goods. Thus, the utility function is u(x; y) = v(x) + y where x is the number of units of the discrete good and y is spending on all other goods. The price of the discrete good is p and the price of the composite good is 1: It is useful to describe the consumer demand for the discrete good in terms s of reservation prices. A reservation price is dened as the price at which the consumer is just indierent between consuming or not consuming the good. Thus, the reservation price this consumer would assign to consuming one unit of the discrete good is r1 = v(1) v(0);

the reservation price this consumer would assign to consuming a second unit of the good is r2 = v(2) and so on. The relation between these reservation prices and the quantity of the discrete good demanded is as follows. If n units are demanded, then it must be that rn p rn+1 v(1);

That is, the actual price of the good must be less than or equal to the reservation price for purchasing an nth unit of the good and greater than or equal to the reservation price for purchasing an (n + 1)st unit of the good. 2

To see this more clearly, consider an example. Suppose the consumer chooses to consume 6 units of the discrete good when its price is p. Then it must be that u(6; m 6p) u(x; m px).

for all x. In words, this says that the utility from consuming 6 units of the good and spending the rest of the consumer income on other goods must be greater than the s utility from choosing any other number of units and spending the rest of income on other goods. This means, given the quasilinear utility function assumed here, that v(6) + m for any x. 6p v(x) + m px

For example, this must hold for x = 5: 6p v(5) + m 5p

v(6) + m which implies v(6)

v (5) = r6

p.

Since the general equation must also hold with x = 7, we get v(6) + m 6p v(7) + m 7p

which can be rearranged to give p v(7) v(6) = r7

This shows that if 6 units are demanded, then the price of the discrete good must be between r6 and r7 . Thus, the list of reservation prices contains all the information necessary to describe the demand behavior. We can see that the graph of the reservation prices forms a staircase; this is the demand curve for a discrete good.

Graph: Reservation Prices and Consumer Surplus

PRICE r1 r2 r3 r4 r5 r6

QUANTITY

Constructing Utility from Demand

We have seen how to construct the demand curve given reservation prices or the utility function. We can also do the same operation in reverse; if we are given the demand curve, we can construct the utility function at least in this special case. At one level, this is just a trivial operation of arithmetic. Since we know that r1 = v(1) r2 = v(2) r3 = v(3) v(0) v(1) v(2)

and so on, we could calculate, say, v(3); by adding up both sides to get v(3) v(0) = r1 + r2 + r3

It is then convenient to set the utility from zero units to zero, so v(3) = r1 + r2 + r3 . More generally, v(n) is just the sum of the rst n reservation prices. We can illustrate this graphically:

Graph: Reservation Prices and Gross Consumer Surplus

PRICE r1 r2 r3 r4 r5 r6

QUANTITY

The utility from n units is the area of the rst n bars. This is the gross benet or gross consumer surplus from consuming x, the discrete good. In most applications, we want to know something related but dierent. The expression v(n) np

is known as net consumer surplus, or, more commonly, just consumer surplus (CS). It measures the net benets from consuming n units of the discrete good. In words, CS is the utility from consuming the discrete good, v(n), minus the reduction in expenditure on consumption of other goods, pn. We can illustrate this as below:

Graph: Reservation Prices and Net Consumer Surplus

PRICE r1 r2 r3 p ----r4 r5 r6

QUANTITY

Thus, CS is the area under the demand curve but above price. Two other interpretations of CS are useful. Suppose that the price of the discrete good is p. Then the value that the consumer places on the rst unit of consumption of that good is r1 , but he only has to pay p for it. This gives him a surplus of r1 p

from consumption of the rst unit. The consumer values the second unit of the discrete good at r2 , but again only has to pay p for it. This second unit therefore gives him a surplus of r2 p

and so on through all the units of the discrete good purchased. Adding this up over the n units purchased implies that CS = r1 + r2 + : : : + rn np 7

Since the sum of the rst n reservation prices gives us the utility of consuming n units, we can also write this as CS = v(n) np,

as before. Thus, we can think of CS as the sum of the reservation prices, minus expenditure on the good. We can interpret consumer surplus in still another way. Suppose the consumer is consuming n units of the discrete good and paying np dollars to do so. How much money would he need to induce him to give up his entire consumption of this good? Let R be the required amount of money. Then R must satisfy v(0) + m + R = v(n) + m np

Since v(0) = 0 by assumption, this reduces to R = v(n) np

which is the same expression for consumer surplus that we derived above. Thus, CS can be thought of as the amount of money necessary to get the consumer to give up his entire consumption of the good. Three further thoughts about CS: 1. In many cases we care not just about the CS of a given consumer but about the CS of a group of consumers. In that case we could add up the CS of each consumer to get a measure of consumerssurplus, rather than a consumer surplus. s 2. We have shown that the area underneath the demand curve for a discrete good measures the utility from the consumption of that good. One possible limitation of this approach is that many goods are not discrete. For example, one can buy any amount of gasoline, not just a tank full or none at all. In many applications, however, the discrete approach might be a good approximation to a continuous demand curve. It is an empirical question as to whether this approximation is good enough, and for what purposes. 3. A dierent limitation of the CS approach is that it assumes quasilinear utility. This functional form means that the price at which a consumer is willing to buy good x does not depend on the amount of money he has left over to spend on good y. 8

This does not hold for general utility functions. Instead, the reservation price for good 1 will depend on how much of good 2 is being consumed. Quasilinear utility eliminates any income eect, which simplies the analysis. It also means, however, that if utility is not quasilinear, then the formulas above are only an approximation. OPTIONAL MATERIAL: The assumption of a discrete good is not necessary if we use calculus to characterize CS. Assume the consumer solves max v(x) + y subject to px + y = m

Substituting out for y using the constraint and then taking the derivative with respect to x gives us the FOC v 0 (x) = p, and this implies an inverse demand function p(x) = v 0 (x). This just says that the price the consumer is willing to pay for x units of the good is determined by the marginal utility function for the good. Now consider the following. Given that v(0) = 0 by assumption, we can write Rx Rx v(x) = v(x) v(0) = 0 v 0 (t)dt = 0 p(t)dt

In words, this says that the utility from consuming x units of the good, given quasilinear utility, is the area under the demand curve. So, the usual denition of CS is exactly right under these assumptions. END OPTIONAL MATERIAL

Compensating and Equivalent Variation

The CS approach to quantifying the eect of price changes on consumer well-being relies on various assumptions or approximations. For these reasons, it is useful to examine other approaches. 9

Assume that the consumer initially faces the prices (p1 ; p2 ) and consumes the bundle (x1 ; x2 ). The price of good 1 then increases from p1 to p1 , and the consumer b changes his consumption to (b1 ; x2 ). x b How much does this price increase hurt the consumer? answer this in two ways.

It turns out we can

The rst asks how much money we would have to give the consumer after the price change to make him just as well o as he was before the price change. This is illustrated in the following gure:

10

GRAPH: Compensating Variation

x2 CV

Optimal bundle at price p1^ (x1^, x2^) (x1*, x2*) Slope = -p1

m*

Slope = -p1^ x1
A The idea is that we take the new slope of the budget line as given and ask how far up we would have to shift this line to make it tangent to the indierence curve that passes through the original consumption point (x1 ; x2 ). This change in income is called the compensating variation (CV ); it is the amount of money it would take to compensatethe consumer for the price change. The second way to answer the question (of how much the price increase harms the consumer) is to ask how much money would have to be taken away from the consumer before the price change to leave him as well o as he ends up being after the price change. This is illustrated in the following gure:

11

GRAPH: Equivalent Variation

x2 m* EV

[
E

(x1^, x2^) (x1*, x2*)

Optimal bundle at price p1*

Slope = -p1*

Slope = -p1^ x1
B The idea is that we nd the shift in the original budget line that makes it tangent to the indierence curve that the consumer ends up on as the result of the price change. This change in income is called the equivalent variation (EV ); it is the amount of money that is equivalentto the loss in income the consumer suered as the result of the price increase. We can also think of the EV as the maximum amount of income the consumer would pay to avoid the price change. Note that in general the CV and the EV do not have to be the same. In words, the amount of money the consumer would be willing to pay to avoid a price change could be dierent from the amount of money the consumer would have to be paid to compensate him for that price change. The reason is that a dollar is worth dierent amounts to the consumer at dierent sets of prices, since the consumer will purchase dierent amounts of consumption at dierent prices. 12

In geometric terms, the CV and EV are dierent ways to measure the distance between two indierence curves. In each case we are measuring the distance by seeing how far apart their tangent lines are. In general this depends on the slope; that is, on the prices that we choose to determine the budget lines. However, the CV and EV are the same in one case: quasilinear utility. In this case the indierence curves are parallel, which means distance is the same no matter where measured. In fact, in the quasilinear case, CV = EV = CS We can see this explicitly as follows. v(x1 ) + x2 . In this case we know from previous material that the demand for good 1 can be written as x1 (p1 ). That is, demand for good 1 depends only on the price of good 1, not on the price of good 2 or income. Now let the price increase from p1 to p1 . b EV . x1 (p1 ) and gets utility v (x1 ) + m p1 x1 We are going to compute the CV and Suppose the consumer has the utility function

We know that at p1 the consumer chooses

And, at p1 the consumer chooses b x1 = x1 (b1 ) b p 13

and gets utility v (b1 ) + m x p1 x1 bb

Then the CV , which equals the amount of extra money the consumer would need after the price change to make him as well of as he was before the price change, must satisfy v (b1 ) + m + CV x so CV = v (x1 ) p1 x1 = v (x1 ) + m bb p1 x11 . p1 x1 ,

Similar reasoning shows that the equivalent variation, which is the amount of money we would have to take away from the consumer before the price change to leave him with the same utility that he would have after the price change, must satisfy v (x1 ) + m which implies EV = v (x1 ) v (b1 ) + p1 x1 x bb p1 x1 . EV x p1 x1 = v (b1 ) + m p1 x1 bb

v (b1 ) + p1 x x bb

This is the same expression as that for the CV . One useful exercise is to try this with a utility function that is not quasilinear and show that in general the CV and EV are not the same. The CS from the price change is just the utility of the consumer choice under s the initial price minus the utility of the consumer choice under the new price, which s is again the same expression.

Cost-Benet Analysis

One key application of the material we have just examined is analyzing the welfare implications of various policies. We will consider many examples later in the course, but it is useful to consider a simple case here. We will use CS rather than CV or 14

EV , since CS is approximately right under reasonable assumptions and by far the most commonly used approach in practice. We will also use the concept of producer surplus, even though we will not dene it carefully until after developing the theory of the rm. For now, it is exactly what you learned in EC 10: the area above the supply curve but below price. The example we want to consider is rent control. Assume we have standard demand and supply curves for apartments. In the absence of rent control the equilibrium of this market would look like the following graph:

15

GRAPH: The Supply and Demand for Apartments

p S Consumer's surplus p* Producer's surplus D x* x

The equilibrium quantity is q0 and the equilibrium price is p0 . Now assume that a government body imposes a maximum rent that can be charged, pc , with pc < p 0 . What happens to the welfare of consumers and producers in this market? One possible answer is based on the following diagram:

16

GRAPH: Supply and Demand with Rent Control

p A S B CS p0 pc PS O C D qc = qe q0 x E

pe

This graph shows that at the controlled price, the supply of apartments is qc , which is less than q0 : Consumer surplus declines from the triangle AEp0 to the trapezoid ABCpc . Producer surplus declines from the triangle OEp0 to the triangle OCpc . Under one key assumption, the overall eect on welfare is therefore a loss equal to the triangle BEC. This assumption is that the people who get the apartments at the controlled price are the ones who value them the most. In practice, this is unlikely, so the loss in welfare is probably greater than the diagram would suggest. Some people who end up with rent-controlled apartments do not value them that highly, while some who value them a lot do not get them.

17