II. CONSUMER DEMAND

    B. EXTENSIONS AND APPLICATIONS OF CONSUMER THEORY

    3. MEASURING CHANGES IN CONSUMER WELFARE

    a. (review of) CONSUMER SUPRLUS

    Recall that consumer surplus is the key to understanding consumer incentives, the pay-offs to consumer decisions, and events which affect consumers.

    Alternatives: Regular 'pay as you go' purchases versus discount buying clubs.

    Example: Athletic clubs

Option 1: Tennis Centre (TC): Price = $10 per session.     Option 2: Athletic Club (AC):  Membership = $100 per month for free court time. Given the demand for tennis time illustrated here: For option 1 (TC):     ? How often would you play at the Tennis Centre?     ? How much would you spend each month? For option 2 (AC):     ? Would you be willing to join? (Available online: Applying consumer surplus)

If you do join:
    ? Will you be in better shape?
    ? Will you be happier?

    Drawback to consumer surplus: partial equilibrium--only see one market at a time.
    A more complete analysis of consumer welfare requires us to make use of general equilibrium framework instead: budget lines and indifference curves.

    Measuring consumer welfare with indifference curves:

    b. COMPENSATING VARIATION (CV) (Also called "willingness-to-pay" analysis.)

Suppose:     I = $30 (your entertainment budget)     X = Video rentals (V, Pv=$2).     Y = Ig, income for other entertainment      (Tip: If you're trying this at home, save some space below your diagram to add another one later.) 2 equally satisfying situations:    Pv   I   U a  $2 $30 Ua a' $1 $21 Ua (Available online: Measuring welfare changes)

    Compare a and a':
    ? How does your utility at a compare to your utility at a'?

    ? How does the money income you need to reach a' compare to what you need to reach a?

    ? How much would you be willing to pay upfront to join a buying club where video rentals cost $1 instead of $2?

    Your willingness-to-pay (WtP) for the price reduction
        = $9=Ia-Ia'=30-21
    This willingness-to-pay measured with indifference curves is called a consumer's COMPENSATING VARIATION.

    Compensating variation (CV): The change in money income (I) which is exactly sufficient to leave utility unaffected by a price change.

    Key results:
    Note1: If a 'discount buying club' tries to collect more than the compensating variation (CV) associated with the price discount, the consumer will be worse off after the price change and won't join. If it collects any less, the consumer will end up better off than before. So CV measures the exact value of the welfare at stake with the price change.

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