Problem 7.

dx
) = 11+ (10 8)(0.5) = 10
dp

(7.3a) x1 = x 0 + p1 p 0
8

(7.3b) EV =

h( p,u1dp
)

10

We do not have an exact functional form for h( p,u1 ) . So our first step is to estimate it using the first
order Taylor approximation. In particular, we are interested in h( p 0 ,u1 ) . [We already know
h( p1,u1 ) , which is equal to x1 .]

h( p1,u1 ) 0 1
(p p )
p
x x

= x( p1,w) + +
x( p1,w)(p 0 p1 )
p w

h( p 0 ,u1 ) h( p1,u1 ) +

= 10 + (0.5 + (0.01)(10)) (8 10) = 10.8

Lets graph our known points, h ( p 0 , u1 ) = 10.8, h ( p1, u1 ) = x1 = 10, and x 0 = 11:

EV =

10

10

h( p,u1 )dp = h( p,u1 )dp = Area of (a + b) = (10 8)(10 0) 12 (10 8) (10.8 10)
8

= (2)(10) 12 (2)(0.8) = 20.8

(7.3c) Now we need to estimate h ( p1, u 0 ) :

h( p 0 ,u 0 ) 1 0
(p p )
p
x x

= x( p 0 ,w) + +
x( p 0 ,w)(p1 p 0 )
p w

h( p1,u 0 ) h( p 0 ,u 0 ) +

= 11 + (0.5 + (0.01)(11)) (10 8) = 10.22

CV =

h( p,u )dp
0

10

10

= h( p,u 0 )dp = Area of (c + d) = (10 8)(10.22 0) 12 (10 8) (11

8

10.22) = (2)(10.22) 12 (2)(0.78) = 21.22

8

(7.3d) CS =

10

x( p,w)
dp = x( p,w)dp = Area of (e + f) = (10 8)(10 0) 12 (10 8) (11 10) =

10

(2)(10) 12 (2)(1) = 21

(7.3e) CV answers the question about how much the government needs to compensate individuals to be as
well off after the tax increase as before. Since our goal is to keep everybody as well off as before and
we are only evaluating the welfare impact of one particular policy, CV is the most appropriate
measure.
dx
is indeed very
(7.3f) CS is equivalent to EV and CV iffdw dx= 0 . This is not the case here. However, dw
close to zero. Hence, CS would be a good estimate of CV in this case.
(7.3g) Tax revenue (TR) = (2)(10) = 20
Deadweight loss associated with EV (DWLEV) = (Area b) = 12 (2)(10.8 10) = 0.8
DWLCV = (Area d) = 12 (2)(11 10.22) = 0.78
DWLCS = (Area f) = 12 (2)(11 10) = 1
Note that DWLEV and DWLCS lend themselves to the interpretation of DWL as the difference between
tax revenue and the change in welfare: DWLCS = CS TR and DWLEV = |EV| TR. Calculating
DWLCV in this way, |CV| - TR, would result in a number much larger than DWLCV = 0.78 calculated
above. (It would be equal to 21.22 20 = 1.22!)
Even though CS is a good estimate of CV in this case, DWLCS is not a good approximation of DWLCV,
since the DWL-values are relatively small. DWLCS overestimates DWLCV by about one fifth.