Download Lecture 19: Compensating and equivalent variations

Microeconomics 2
John Hey
Chapter 19
• The effect on (behaviour and) welfare of a
change in a price.
• Suppose a price facing an individual rises.
• Is the individual worse off?
• Am I worse off if the price of plastic flowers rises?
• Am I worse off if the price of beer rises?
• How much worse off am I?
• Clearly it depends on preferences.
• Preferences determine demands.
• But we know a special case when we can
measure how much worse off someone is...
• ... quasi-linear preferences.
The effect on (behaviour and) welfare of a
change in a price
• We started this course with QUASI-LINEAR preferences,
with money on the vertical axis and the quantity of the
good on the horizontal axis.
• Suppose that the price rises. The individual changes his
or her demand. Also...
• ...the individual is worse off – but by how much?
• Remember that the indifference curves are parallel in a
vertical direction.
• So we can simply measure how much worse off by the
vertical direction between the original indifference curve
and the new (lower) one: the change in the surplus.
• We can also measure this from the demand curve (the
area between the old price, the new price and the curve).
• But what do we do if the curves are not parallel?
The effect on (behaviour and) welfare of a change in a price.
• Consider now NON QUASI-LINEAR
preferences.
• m = 70
• Suppose that the price rises from p = 0.8 to p =
1.25.
• The individual is worse off – but by how much??
• Suppose Stone-Geary preferences.
• Let us go to Maple...
The effect on (behaviour and) welfare of a
change in a price.
• Let us now look at these two variations
with quasi-linear preferences....
Summary
• The Compensating Variation is the amount of
money that we need to give to the individual to
compensate him or her for the rise in the price.
• The Equivalent Variation is the amount of money
that we should take away from the individual at
the original price to make him or her just as
worse off as the rise in the price does.
• Usually the compensating variation is larger than
the equivalent variation (except for quasi-linear
preferences, when they are the same).
• The Change in the Surplus of the individual is
between the compensating variation and the
equivalent.
Chapter 19
• Goodbye!