Introduction to Microeconomics (L11100)

Section 3: Consumer Welfare and Household as Supplier

Lectures 8 - 11

Outline

3.1 Compensating and Equivalent Variations in Income (Lecture 8)

3.2 Consumer Surplus (Lecture 9)

3.3 Labour Supply (Lecture 10)

3.4 Dynamic Consumption (Lecture 11)

3.1 Compensating & Equivalent Variations in Income

3.1.1 Defining CV and EV3.1.2 Compensating Variation3.1.3 Equivalent Variation3.1.4 Examples

Application

“Private insurance subsidy has increased stress on public health system” BMJ News Extra 28th February 2004

•Attempt to get Australians to move away from national health care to private

•Subsidised private premiums by 30% (1999)

•Anyone signing up before age of 30 got lowest premium for life

•What impact did it have? Increased take-up of private health care but drew resources from the national health sector too

3.1 Defining CV and EV

Price changes leads to welfare changes i.e. as P rises, W falls and vice versa. Need to measure this not in utils but in monetary terms.

Compensating Variation - amount of nominal income by which an individual would need to be compensated for a price change to remain at his/her initial utility level

Equivalent Variation - change in nominal income that is equivalent in its effect on utility to a change in the price of a commodity

Real Income - the bundle of goods and services that can be bought. Along an indifference curve, real income is constant

Compensating Variation

Compensates the consumer for a fall in real income as prices rise (or vice versa)

Graphically, the technique we have used so far

The new budget constraint is pulled back (parallel) to the original indifference curve

3.1.2 Compensating Variation

Income or All Other Goods

QABC21

BA

BC32

U1

U2

BC1

3

C

CVCompensating Variation

NEW price ratio

OLD indifference-curve

Equivalent Variation

The amount by which nominal income would have to change to be equivalent to the effect of the price change

Graphically, a new technique

The old budget constraint is moved (parallel) to the new indifference curve

3.1.3 Equivalent Variation

Income or All Other Goods

QA

U1

U2

BC1

BC22 3 1

BA

C

BC3

EV

Equivalent Variation

OLD price ratio

NEW indifference curve

3.1.4 Examples

Is a subsidised price for housing the same as a payment to homebuyers?

Income or All Other Goods

Sq. Ms of HousingBC1

A

B

BC3

U1

U2

BC2

C

EV

Cost of subsidy

Pensioners: fuel gifts or cash payments to keep them warm?

Income or All Other Goods

Fuel Consumption

BC2

BA

U1

U3

BC1

Fuel Gift

CU2

Income or All Other Goods

Fuel Consumption

BC2

B

A

BC3

U1

U2

BC1

C

CV