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Chapter 14 Consumer Surplus (Gross Surplus and Consumer Surplus (The…
Chapter 14
Consumer Surplus
Consumer surplus
A dollar measure of the "happiness" the consumer enjoys from consuming a certain quantity at a certain price
Graphically, the consumer surplus is the area under the inverse demand and above the price
A practical measure for welfare in a market and evaluating policy - we cannot observe utility directly, but we can estimate demand curves
Gross Surplus and Consumer Surplus
The reservation price of the nth unit,
rn
, also measures the dollar value to the consumer of consuming the nth unit
If you give the consumer rn dollars, he would be as happy
as if you give him the nth unit for free
The sum of reservation prices over n units measure the
gross surplus from consuming them
If the consumer values the nth unit at rn, but has to pay p
, his
net surplus
or
consumer surplus
is rn-p
marginal willingness to pay
At the optimal consumption
|MRS|=p1/p2
=> p1=|MRS|p2
If we define good 2 as "money to spend on other goods", then p2=1 and
p1=|MRS|
Hence the height of the inverse demand, p1, measures the consumer's willingness to give up money to get good 1, or his "marginal willingness to pay"
The marginal willingness to pay is also the
reservation price
for that unit: the maximum amount of money the consumer would pay for it
Quasilinear utility
suppose good x is a specific good and good m is money to spend on everything else, and we have
u(x,m)=v(x)+m
Then the inverse demand of x is given by
px=dv(x)/dx
so the gross surplus is given by GS=v(x)
In the case of quasilinear utility, gross surplus is an exact measure of utility
Changes in consumer surplus
Graphic approach
Two other way to measure changes in consumer surplus
Compensating Variation (CV)
original utility, new price
Equivalent variation (EV)
new utility, original price