8.

Monetary Measures, Benefit & Cost

Consumers, Surplus, Producers Surplus
Compensating Variation & Equivalent Variation
Monetary Measures of Gains-to-Trade
Can buy as much gas as you want at $! Per gallon once you enter gas market
o What is the most you would pay to enter market?
Would pay up to the dollar value of the utility you would enjoy once in the market
o How can such gains-to-trade be measured?
Monetary Measured of Utility (gains-to-trade)
3 measures:
o consumers surplus
o equivalent variation
o compensating variation
only on 1 special case all three measures coincide
Evaluating goodness of allocations of resources
what makes a good allocation of resources?
o Utilitarianism
Utilitarianism
Problem of applying
o can we measure the happiness of different people in society?
no way to if a reallocation that makes one person better off but someone else worse off has
increased the SUM of happiness
cant measure & cant compare happiness levels
Workable Criterion
appeal to freedom of exchange approximate benefit in something measurable (money)
the MAX amount that an individual would be willing to pay to obtain it
o no rational individual will pay more for something that it is subjectively worth
o dollar measure of benefit is not same as amount paid
Bernoulli Utility Subjective Valuation
explain behavior under risk
value of an item must not be based on its price, but rather on the utility that it yields
distinguished between monetary value of something *what it can be sold for) and it subjective
value (want-satisfier)
o utility
Rational Consumer Behavior
consumer will not pay more for something that it is subjectively worth to them
is consumer obtains unit for less than the max they are willing to pay bargain (better off)
if subjective value is subject to diminishing Marginal Utility
o then max a consumer is willing o pay for each successive unit diminishes as Q purchases
increases
amount willing to pay.?
$ Equivalent Utility Gains
gas can be bought in lumps of 1 gallon
R1 the most consumer would pay for a 1st gallon (reservation price) for
1st gallon
R1 = dollar equivalend of the marginal utility of the 1st gallon
Has 1 gallon
o R2 most would pay for 2nd gallon
o R2 = dollar equivalent of marginal utility of 2nd gallon
She already has (n 1) gallons of gas Rn most shell pay for nth gallon
Rn $ equiv of MU of nth gallon

o $ equiv of the total change to utility acquiring n gallons of gas at price $Pg each
r1,r2.rn plotted against n = reservation price curve
monetary value of our consumers gain on trading in the gas market at price $Pg?
o $ equiv net utility gain for 1st gallon is $(r1-pg) + $(r2-Pg).. as long as Rn Pg > 0

highest amount youre willing to pay more than the price

o is the price of the good no more than the highest amount I am willing to pay?
knowing max amount we are willing to pay
o gains us nothing
o takes time and thought to ascertain

MV, Willingness to Pay, Individuals Demand Curve

height of individuals demand curve showing highest amount they are willing to pay for each
additional unit of good
o marginal value
o presumes that person knows the amount they are willing to pay for each successive unit
rather than go without it
consumers are willing to pay more for the first unit than for subsequent units
o MV of 1st unit + MV of 2nd unit + . total value to the consumer of all units purchased
o Not same as the amount consumer must pay
Consumer Surplus
Get Total value then can compare this to the amount the consumer actually spends for all those units
Consumer surplus: difference between total value and amount spent
Example:
Buy digital camera
o Advertised for $300
o Will not pay $301 $300 is max you will pay for it
o Camera on sale for $250 at store
o Left with extra $50 consumer surplus

Measuring CS for all Buyers, Cont Demand Function

QD is a continout function of price
To find CS at some market price
o Invert demand function to get P as function of Qd
o Then
1. Find Qd(P)
2. Find area under Demand function from 0 to Qd(P)*
a. By integrating or adding area of triangle & area of rectangle) total value to
all buyers

3. Find area representing total expenditure (P*[Qd(P)])

4. Cs different between TV & TE
Example:
Qd(P) = 200 20P
Market price = $5
Total CS (to all actual buyers) ?

Compensating Variation & Equivalent Variation

Compensating & Equivalent Var: 2 additional $ measures of total utility caused by price change
Compensating Variation
P1 rises
Consumer worse off busget set shrinks
What is the least extra income that , at the new prices (higher prices of g1) just restores the
original utility
o What is the least extra income that COMPENSATES for the price rise?

A tax is put on 1 good raise revenue on commodity taxation

o Can determine tax revenue (tax/unit x # of units bought)
What is the sacrifice made by consumer when tax introduced
o Can measure as amount of required compensation for price increase one money measure
sacrifice
Always more than tax revenue raised (excess burden)

Equivalent Variation

P1 rises
What is the least extra income that (at the original prices) just restores consumers original utility
level?

What is the LOSS of income (if prices didnt change) that is equivalent to the sacrifice made by
consumer when the price of g1 increased
o Monetary measure of loss

Relationship 1: when consumers preferences are quasilinear all 3

same
Producer Surplus
Difference between min price at which producers make a unit available
(marginal cost of production) and the price actually received
For all units but last (marginal unit), price received will exceed min price
(Marginal cost)
o Bonus
PS = Revenue Total Variable Cost (Revenue less avoidable costs)

measures are the

Total Surplus
CS =
buyers)
paid by buyers)
o Measures net benefit buyers receive from buying the good
PS = (amount received by sellers) (cost to sellers)
o Measures the net benefit sellers receive from producing/selling good
Total surplus = CS + PS
o Measures the NET BENEFIT from trade in a market
o Value created
Excess of value of the g/s over value of resources used in producing it
Implication
Unit of a good more highly valued by buyers than it costs
o (good subjectively worth more than resources used to produce it)
o value created by production

(value to
(amount

if all units for which

o buyers valuation is at least as large as value of resources used are produced and made
available
then max net benefit (value) is created
if for marginal unit (last) produced
o buyers are willing to pay more then marginal resource cost
OR
o marginal cost of production exceeds buyers valuations
the wrong quantity is traded
there is scope for an increase in amount of value created

Markets Allocation of Resources

determined by interaction of many self-interest buyers and sellers
is the markets allocation of resources desirable?
Would different allocation of resources make society better off?
o Use total surplus as a measure of societys well-being
Total surplus
o CS + PS = (value to buyers cost to sellers)
Allocative Efficiency
Q traded is consistent with allocative efficiency when
o Sum of CS & PS is maximized
All units for which buyers are willing to pay at least the marginal cost of production are
produced and sold
At that specific Q

Deadweight Loss
less of a g/s than that Q at which willingness to pay = marginal production cost is produced
o some units might have been produced when valuation > marginal resource cost
not produced anymore
exceed of benefit over cost represent net surplus that couldve been obtained but is not

Causes of DWL
taxes
price controls
externalities
market power monopoly firms produce too little
Benefit- Cost Analysis
measure in money units the net gain/loss caused by market intervention (imposition/removal of
market regulation)
o by using measures CS & PS