Title: Microeconomics / Q1 / lecture7

Q: positive economics
A: consists of studying economic phenomena only to understand those phenomena, not to make policy recommendations (or any other kind of recommendations)

Q: normative economics
A: To make policy recommendations

Q: welfare analysis
A: examines the impact of different economic (and other) policies on consumers’ welfare, as measured by utility (more precisely, by the money required to reach a certain level of utility, via the expenditure function)

Q: When is a consumer worse or better off?
A: worse off: v(p1, w) - v(p0, w) < 0
better off: v(p1, w) - v(p0, w) > 0

Q: Describe what this is doing:
A: It is an indirect utility function that “converts” utility into the amount of
money needed for a consumer to attain the utility that he
or she could obtain with wealth w and facing prices p.

Q: reference prices
A: p0 and p1

Q: equivalent variation (EV)
A: compares the new level of utility
attained (u1) to the previous level of utility attained (u0),
when both levels of utility are evaluated at the old prices.
If the change in prices leads to an increase (decrease) in
utility, EV shows much wealth would have had to
increase (decrease) under the OLD PRICES to lead to
the NEW UTILITY level attained under the new prices
(and the initial wealth). Notice that EV < 0 if utility
decreases (and > 0 if utility increases) after prices change.

Q: compensating variation (CV)
A: The compensating variation compares the new level of
utility attained (u1) to the previous level of utility attained
(u0), when both levels of utility are evaluated at the new
prices. If the price change increases (decreases) utility, CV
shows how much wealth, under the NEW PRICES, must
be given to (taken from) a “planner” to keep the consu-
mer at the OLD UTILITY level. As with EV, CV < 0 if
utility decreases, and > 0 if utility increases, after prices
change. (The amount to compensate the consumer = -CV.)

Q: analyze the graphs:
A: In these diagrams, the price of good 2 does not change;
only the price of good 1 changes. Price of good 1 decreases.

When only one price changes, Equivalent Variation (EV)
and Compensating Variation (CV) can also be shown in
terms of area “under” (more specifically, to the left of)
the Hicksian demand curve.

Q: why is equivalent variation a larger area (larger amount of money) than compensating variation?
A: EV > CV when the good for which the price
changes is a normal good, and EV < CV when it is an
inferior good. If the demand for the good does not change
when wealth rises (holding prices constant) then EV =
CV. This is the case because for such a good we have:
all three curves in the above diagram are identical.
In this case, and only this case, the welfare change is the
area to the left of the Walrasian (Marshallian) demand
curve.

Q: deadweight loss of commodity taxation
A: The one on the left is
for the Hicksian demand based, using equivalent
valuation (EV). The intuition is that the consumer’s loss
of utility, evaluated in money terms, is the shaded area
plus the box immediately to the left. The gain in
government revenue is that box to the left, so the
difference is the shaded area.

Q: area variation (AV)
A: normal good, we have EV > AV > CV. Analogously,
when the good in question is an inferior good, we have
EV < AV < CV.

strong axiom of revealed preference