Welfare Measure with Price Changes

Compensating Variation (old utility, new prices)

Price Decrease
The income that could be taken away from the consumer to make
them as happy as before
Price Increase
The income that would be given to make the consumer as happy
as before the change
Equivalent Variation (new utility, old prices)
Price Decrease
The income that would have to be given to consumer to keep it at
the higher price
Price Increase
The income that the consumer would pay to keep it at the lower
price
Marshallian view of CS
If consumer surplus is to be useful construct, it
must be capable of being observable in the
real-world.
Marshallian CS is basically the area under the
demand curve, above price paid, from zero to
the amount purchased.
Does not take into the consideration the income
effect resulting from charging the consumer the
intramarginal values for each successive unit.
Two Different Demand Curves
Hicks Demand
Compensated
Utility held constant
Marshallian Demand
Uncompensated
Original demand
Expenditure Function
The dual problem is to allocate income so as
to reach a given utility level with the least
expenditure.
Reverse the problem.
Primal
Y P X P I t s
Y X U Max
Y X
+ = . .
) , (
Dual
) , ( . . Y X U U t s
Y P X P Min
Y X
=
+
Solution gives us:

Maximum utility (U*) with

Income constrained to
I
Solution gives us:

Minimum Expenditure (I*) with

Utility constrained to
U
Definition: Indirect Utility Function
Use utility maximization to derive optimal values of X
as a function of price and income.
) , ,..., , (
) , ,..., , (
2 1
*
2 1 1
*
1
I P P P X X
I P P P X X
n n n
n
=
=

Now substitute X* into the utility function to get

maximum utility.
U(X
1
*,X
2
*,,X
n
*)
( )
) , ,..., , (
) , ,..., , ( ),..., , ,..., , (
2 1
2 1
*
2 1
*
1
I P P P V
I P P P X I P P P X U
n
n n n
=
=
V is the indirect utility function = maximum utility as
a function of prices and income.
Can in some cases be estimated directly.
Definition: Expenditure Function
Minimize expenditure, subject to =U().
) , , (
) , , (
*
*
U P P Y Y
U P P X X
Y X n c
Y X c c
=
=
Optimal solution expressed as:
) , , ( ) , , ( *
* *
U P P Y P U P P X P I
Y X c Y Y X c X
+ =
E is the expenditure function = minimum
expenditure utility as a function of prices and utility.
Derive compensated
Demand curves
) , , ( ) , , ( * * U P P E U P P I I
Y X Y X
= =
) , ( . . Y X U U t s
Y P X P Min
Y X
=
+
Envelope Theorem (EMP)
The Hicksian demand functions are the first
partials of the expenditure function.



We get the same demand path of price changes
even if other prices change.
Area below the Hicksian demand functions are
always compensating variation.
} }
=
c
c
=
1
0
1
0
) , ( * ) , ( *
*
0 1 0 0
p
p
i
i
p
p
i
H
i
U p I U p I dp
p
I
dp x
Envelope Theorem (UMP - Roys
Identity)
The Marshallian demand functions are NOT in general
partial derivatives of some integral function.
They are the first partials of the indirect utility function
divided by the marginal utility of income.



This is the sum of changes in utility as price changes the
1/
M
that converts change in utility to $$. The conversion
factor changes with price.

If marginal utility of money (1/
M
) is constant then we get

} } }
c
c
= =
i
i
M
i
M
i
M
M
i
M
i
dp
p
U
dp x dp x
* 1
) (
1

)] , ( ) , ( [
1 * 1
0 1
I p U I p U dp
p
U
dp x
M
i
i
M
i
M
i
=
c
c
=
} }

Example
Derive compensated demand curves from
dual problem
XY U t s
Y P X P Min
Y X
=
+
. .
( )
0
0
0
= =
= = =
= = =
+ + =
XY U
d
dL
X
P
X P
dY
dL
Y
P
Y P
dX
dL
XY U Y P X P L
Y
Y
X
X
Y X

(1) Set up Lagrangian and solve FOCs:

Y
X
X
Y Y X
P
X P
Y
and
P
Y P
X
X
P
Y
P
=
= =
(2) Use first two FOCs to solve for
X and Y
2 / 1
* 2
2 / 1
* 2
0
0
|
|
.
|

\
|
=
|
|
.
|

\
|
= =
|
|
.
|

\
|

|
|
.
|

\
|
=
|
|
.
|

\
|
= =
|
|
.
|

\
|

U
P
P
Y
P
P
Y U
P
Y P
Y U
U
P
P
X
P
P
X U
P
X P
X U
Y
X
c
X
Y
X
Y
X
Y
c
Y
X
Y
X
(3) Derive compensated demand for X
c
and Y
c
.
(4) Derive Expenditure Function (Minimum expenditure necessary to maintain
constant utility, )
* *
*
c Y c X
Y P X P I + =
( )
5 . 0
5 . 0
5 . 0 5 . 0
5 . 0
5 . 0 5 . 0
5 . 0
5 . 0
5 . 0
5 . 0
5 . 0
5 . 0
2 / 1 2 / 1
2 U P P
U P P U P P U
P
P
P U
P
P
P
U
P
P
P U
P
P
P
Y X
Y X Y X
Y
X
Y
X
Y
X
Y
X
Y
X
Y
X
=
+ = + =
|
|
.
|

\
|
+
|
|
.
|

\
|
=
(5) Indirect Utility function is (at A):
Y X
P P
I
U
4
2
=
A
Compare to Ordinary (uncompensated)
Demand
Y P X P I t s
XY Max
Y X
+ = . .
( )
0
0
0
= =
= = =
= = =
+ =
Y P X P I
d
dL
P
X
P X
dY
dL
P
Y
P Y
dX
dL
Y P X P I XY L
Y X
Y
Y
X
X
Y X

Y
X
X
Y
Y X
P
X P
Y
and
P
Y P
X
P
X
P
Y
=
= =
*
*
(1) Use first two FOCs to solve for
X* and Y*
X
u X
Y
X
Y X Y X
P
I
X X P I
P
X P
P X P I Y P X P I
2
0 * 2
0
*
* 0 * *
*
= =
=
|
|
.
|

\
|
=
(2) Demand for X, X*, is found by substituting Y* into 3
rd
FOC and solving for X*
(3) Substitute X* into Y*, and get Y*
Y
u
P
I
Y
2
*
=
Compare
Ordinary
Compensated
X
u
P
I
X
2
*
=
Y
u
P
I
Y
2
*
=
Y X
P P
I
U
4
2
=
2 / 1
*
2 / 1
*
|
|
.
|

\
|
=
|
|
.
|

\
|
=
U
P
P
Y
U
P
P
X
Y
X
c
X
Y
c
( )
5 . 0
2 U P P I
Y X
=
Demand
(uncomp.)
Indirect
Utility
Expenditure
Function
Comp.
Demand
Derive the Slutsky Equation

( ) ) , , ( , , ) , , (
* * *
U P P I P P X U P P X
Y X Y X u Y X c
=
Primal and dual give us same demand at the optimal bundle
X
u
X
u
X
c
dP
dI
dI
dX
dP
dX
dP
dX
* * * *
+ =
Differentiate both sides
Re-arrange
|
|
|
.
|

\
|
|
|
|
.
|

\
|
=
=
=
=
=
=
=
=
=
0
0
*
0
0
*
0
0
*
0
0
*
Y
X
Y Y Y
dP
dP
u
dP
dU
X
dP
dI
X
c
dP
dU
X
u
dI
dX
dP
dI
dP
dX
dP
dX
( )
|
|
|
.
|

\
|
=
=
=
=
=
=
=
0
0
*
*
0
0
*
0
0
*
Y
X
Y Y
dP
dP
u
dP
dI
X
c
dP
dU
X
u
dI
dX
X
dP
dX
dP
dX
Note that I* = P
X
X + P
Y
Y =>
*
*
X
dP
dI
X
=
Therefore
Which is the Slutsky equation we discussed earlier..
Slope of Ordinary Demand Function =

Slope of Compensated demand (Slope of Engel Curve)(X
*
)
Calculate Substitution and Income Effects
What is the
Substitution Effect?
X
c
(P
1
;U
0
) - X
u
(P
0
;U
0
)

What is income
Effect?
X
u
(P
1
; U
1
) - X
c
(P
1
;U
0
)
P
0

P
1

X
Y
S I
I
1

A
B
C
U
0

U
1

Summary: Whats the point?
Ordinary demand (X
u
)
Derived from Utility Maximization
Compensated demand (X
c
)
Derived from Expenditure Minimization
Relationship between Ordinary and compensated demand
Slutsky Equation
Slope of Ordinary Demand Function =
Slope of Compensated demand (Slope of Engel Curve)(X*)
Slope is same if income effect = 0 (dx/dI = 0)

Normal Good: (dX/dI >0) =>


Inferior Good: (dX/dI <0) =>


Giffen Good: (dX/dI <0) => slope of ordinary demand curve is +
X
u
X
c
dP
dX
dP
dX
<
X
u
X
c
dP
dX
dP
dX
>
x
P
X

X
u

X
c

X
u
X
c
dP
dX
dP
dX
<
Normal Good:
For any change in price, you get a bigger
shift along the ordinary demand curve
than along the compensated demand curve.

Income effect reinforces substitution effect
For a price increase, EV<CS<CV. The
intuition behind this is that for a normal
good more income is required to
compensate the individual for a rise in price
to maintain utility than income to be taken
away from an individual such that he lies on
a same lower utility.
Price changes have two effects:
Change the optimal bundle
Change income
When measuring change in CS, need to account for
both effects
Marshallian CS =

Hicksian CS =

They will differ, depending on income effects
Difference is typically small for small (marginal) price
changes
Summary
}

1
) | (
X
O
X
P
P
X X c
dP P X
}

1
) | (
X
O
X
P
P
X X u
dP P X