Advanced Microeconomics

Saba Yifredew
Department of Economics
Addis Ababa University
Email: Saba.Yifredew@aau.edu.et
Prices and Welfare changes
Consumer surplus
Compensating Variation
Equivalent Variation
Chapter closure : Empirical
applications
Quantitatively evaluate the effect of price changes
• Comparative statics analysis
• Recall Consumer Surplus
• Models to assess the impacts of given shocks or policies on a specific
economy.
• To quantitatively evaluate how much better or worse off the households are.
• Direct and indirect utility functions are purely ordinal in nature, we can only
analyze the direction of change.
• Use the money metric utility function (Expenditure function)
• Obtain monetary measures of the welfare effects of different policy scenarios.
• The most common of these measures are equivalent variations (EV) and
compensating variations (CV)
 Consumer Surplus
• The individual’s demand curve can be seen as the individual’s willingness to
pay curve.
• On the other hand, the individual must only actually pay the market price
for (all) the units consumed.
• For example, you may be willing to pay $40 for a haircut, but upon arriving
at the stylist, discover that the price is only $30
• The difference between willingness to pay and the amount you pay is the
Consumer Surplus
 Consumer Surplus
Consumer Surplus = area of triangle
=1/2bh
Price =1/2(16-8)(10)
16 =40

Consumer Note: This calculation only works for a linear

Surplus demand Curve. Else we have to use integrals

10 Quantity 5
 Consumer Surplus
Definition: The net economic benefit to the consumer due to a
purchase (i.e. the willingness to pay of the consumer minus the
actual price) is called consumer surplus.

The area under an ordinary demand curve and above the market
price provides a measure of consumer surplus.
 The change in consumer surplus: Welfare
When p increase from p10 to p11, lost consumer surplus is the areas of trapezoid p10p11fg

p1 x1(p1), the consumer’s ordinary (Marshallian) demand curve for commodity 1

f
p11

Lost CS
p10 g

x*1
x11 x10
𝑷𝟏𝟏
∆𝑪𝑺 = න x1(p1)𝒅𝑷𝟏
𝑷𝟏𝟎
Compensating and Equivalent variation

• Initial( starting) Equilibrium

• Utility Ustart
Compensating and Equivalent variation
• The price of Good 1 increases hence after
the price increase a new equilibrium
• Steeper budget line and utility denoted by
Uafter
• This analysis will give us Masrshallian
demand curves
• Now if we think of compensating the
consumer for the price increase there are
two ways.
• Compensating Variation and Equivalent
variation
Compensating and Equivalent variation
Compensating Variation

• Compensate after the price change.

• At the new price, how much income
needs to be given so that he has the
utility level he had initially Ustart
• This is given by expenditure as shown by
the green line.
Compensating and Equivalent variation
Compensating Variation
• Compensate after the price change.
• At the new price, how much income needs to
be given so that he has the utility level he had
initially Ustart

• This is given by expenditure as shown by the

green line.
𝑝𝑎𝑓𝑡𝑒𝑟 ℎ
• 𝐶𝑉 = ‫𝑝׬‬ 𝑥𝑖 𝑝1 , 𝑝2 , 𝑢𝑏𝑒𝑓𝑜𝑟𝑒 𝑑 𝑝 1�
𝑏𝑒𝑓𝑜𝑟𝑒
 Compensating and Equivalent variation
Equivalent Variation
• Compensate before the price change.
• At the old price, how much income needs to
be taken from the consumer so that he has
the utility level he had after the price
change i.e Uafter.
• Reduce money from the consumer
• This is given by expenditure as shown by the
red line.
• The amount of money the consumer will be
willing to pay to avoid the price increase
• EV, or equivalent variation is the
adjustment in income that changes the
consumer’s utility equal to the level that
would occur IF the event had happened.
Compensating and Equivalent variation
Equivalent variation Variation
• Compensate before the price change.
• At the old price, how much income needs to
be taken from the consumer so that he has
the utility level he had after the price change.
• Reduce money from the consumer
• This is given by expenditure as shown by the
red line.
𝑎𝑓𝑡𝑒𝑟 𝑏𝑒𝑓𝑜𝑟𝑒
• EV= e(𝑝1 , 𝑝2 , Uafter) - e(𝑝1 , 𝑝2 , Uafter)

𝑝𝑎𝑓𝑡𝑒𝑟 ℎ
• E𝑉 = ‫𝑝׬‬ 𝑥𝑖 𝑝1 , 𝑝2 . , 𝑢𝑎𝑓𝑡𝑒𝑟 𝑑 𝑝1
𝑏𝑒𝑓𝑜𝑟𝑒
Derivation of the Hicksian/Compensated demand
curve
• So we must consider the Hicksian
demand(compensated demand to find
welfare changes)
• The curve xc (sometimes xh) shows how the
quantity of x demanded changes when px
changes, holding py and utility constant.
• Additional expenditure/income to keep the
same level of utility i.e. stay on the same IC
• That is, the individual’s income is
‘‘compensated’’ to keep utility constant.
Hence xc reflects only substitution effects of
changing prices.
Application: Welfare Change (CV)
• Measure the change in welfare
• That an individual experiences if the price of good x increases
from p0x to p1x
• To reach U0
• Expenditure at p0x: E(p0x,py,U0)

• Expenditure at p1x: E(p1x,py,U0)

• To compensate for the price increase –
compensating variation (CV) of:
CV = E(px1,py,U0) - E(px0,py,U0)

15
 Consumer Surplus
• Consumer surplus

• The area below the compensated demand curve and above the market
price
• The extra benefit the person receives by being able to make market
transactions at the prevailing market price

• shaded area in figure (CV) lowers consumer surplus “triangle”

➔ measure of change in welfare

16
 5.8 (b) Compensated demand curve
•Showing Compensating Variation
Price

p2x

p1x B

A
p0x

xc(px,…,U0)

x1 x0 Quantity of x
•If the price of x increases from p0x to p1x, this person needs extra expenditures of CV to remain on the U0
indifference curve. Integration shows that CV can also be represented by the shaded area below the
compensated demand curve in panel (b).
17
Using the compensated demand curve to show CV
• The derivative of the expenditure function with respect to px
is the compensated demand function. Shepard’s Lemma

E ( px , p y , U )
x ( px , p y , U ) =
c

px

18
 5.8 (a) Indifference curve map
•Showing Compensating Variation
Spending on
other goods ($)
E(p1x,py,U0) E(p1x,py,U0)
CV

E(p0x,py,U0)
y1
y2
y0
U0
U1
E(p0x,py,U0)

x2 x1 x0 Quantity of x
•If the price of x increases from p0x to p1x, this person needs extra expenditures of CV to remain on the U0
indifference curve. Integration shows that CV can also be represented by the shaded area below the
compensated demand curve in panel (b).
19
 Compensated variation...Consumer Surplus?

• Using the compensated demand curve to show CV

• The amount of CV required: integrate across a sequence of small
increments to price from px0 to px
• This integral is the area to the left of the compensated demand
curve between px0 and px1

p1x p1x

CV = ò ¶E / ¶ px dpx = ò ( px , py ,U 0 ) dpx
x c

px0 px0

20
 5.8 (b) Compensated demand curve
•Showing Compensating Variation
Price

p2x

p1x B

A
p0x

xc(px,…,U0)

x1 x0 Quantity of x
•If the price of x increases from p0x to p1x, this person needs extra expenditures of CV to remain on the U0
indifference curve. Integration shows that CV can also be represented by the shaded area below the
compensated demand curve in panel (b).
21
 Consumer Surplus
• But often we measure consumer surplus from the Marshallian demand.

• Welfare changes and the Marshallian demand curve

• Empirical studies often use Marshallian demand curves

• Consumer surplus
• The area below the Marshallian demand curve and above price
• Shows what an individual would pay for the right to make voluntary transactions at this price
• Changes in consumer surplus measure the welfare effects of price changes

22
Marshallian and Hicksian Demand Curves
Y Price Increase

U0
U1
P0
P1
X1M X1H X0 X
Marshallian and Hicksian Demand Curves
Price Increase
Px

Pa x x

Pi x DM

DH

X1M X1H X0 Qx
Marshallian and Hicksian Demand Curves
Px

Pa

Pi DM

DH|U(after) DH|U(initial)
Qx
 Relationship between EV,CS and CV
EV is measured on Hicksiand demand DH|U(after). The
consumer will be compensated (income taken away
CV is measure on Hicksian Px from him so that he maintains the utility level after the
demand Compensated price increase but at old price(initial price). Because
demand DH|U(initial) . The U(after) < U(initial). Hence the Hicksian demand has
consumer will be shifted inwards. Recall that the Hicksian demand is
compensated to maintain M
Pa A drawn for a given level of utility. EV is 𝑃𝑎 𝑀𝑁𝑃𝑖 .
intial utility at new higher
price. CV
CV=𝑃𝑎 𝐴𝐵𝑃𝑖 .
EV
CS
CS is measured on the Pi B
oridnary demand as N
DM
𝑃𝑎 𝑀𝐵𝑃𝑖 . Note that we
cannot compute CV and
DH|U(after)
EV but rely on CS. DH|U(initial)
Qx
 Comparison of CV, EV & CS
• The CS is empirically observable (the demand function can be
estimated by looking at combinations of price and demand
observed at different times
• By contrast, the CV and EV cannot be determined unless we
precisely know the consumers’ preferences. We never observe
preferences directly of course, only behaviour.
• It turns out that for normal goods the consumers’ surplus is
always somewhere in between the CV and EV. CS is an average
of CV and EV.
 Comparison of CS, EV CV
• For a price increase, when this area is evaluated
using the compensated demand curve at the original
price, it is the compensating variation (A+B+C+D).
• When this area is evaluated using the compensated
demand curve at the new price, it is the equivalent
variation (A+B).
• The change in consumers’ surplus is the change in
the area under the Marshallian demand curve, which
is A+B+D. When preferences are quasi-
• Hence, we can see that for a normal good with a linear, there is no income effect
price increase CV>CS> EV. on the amount of x demanded,
and so the three demand curves
are identical, and so
CV=CS=EV.
 Comparison of CS, EV CV
Empirically, we are able to estimate CS, but not EV or CV.
How close an approximation is CS to EV or CV?
• Depends on magnitude of the income effect
• Differences are small for small price changes
• Differences are small if (Marshallian) demand curve is
inelastic
 Excercise: Cobb- douglas
𝑈 𝑥1 , 𝑥2 = 𝑥11/2 𝑥21/2 = 𝑥1 𝑥2 (Recall C-D type utility functions as a precursor to the excercise on the next slide.)

These are the Marshallian and indirect utility functions

𝑀 𝑀
𝑥1𝑚 = and 𝑥2𝑚 =
2𝑝1 2𝑝2
𝑀 𝑀 𝑀
ഥ =
v (𝑝1 , 𝑝2 , 𝑀) =
2𝑝1 2𝑝2 2 𝑝1 𝑝2

These are the Hicksian demand and expenditure function

𝑝2 𝑝1
ഥ
𝑥1 ℎ = 𝑈 ഥ
𝑎𝑛𝑑 𝑥2 ℎ = 𝑈
𝑝1 𝑝2
ഥ 11/2 𝑝21/2 = 2 𝑈
𝐞(𝑝1 , 𝑝2 , 𝑈) = 2 𝑈𝑝 ഥ 𝑝1 𝑝2
 Welfare and Economic change CONT’D
• Exercise
𝑚
• Suppose 𝜐 𝑝1 , 𝑝2 , 𝑚 = , 𝑝1𝑖 = 1, 𝑝2 = 1, and m=100
2 𝑝1 ∗𝑝2
• Note. You are given only the indirect utility function, but you can arrive at Marshallian demand, expenditure function and Hicksian demands
using Roy’s identity, duality and Shepard’s Lemma respectively. See the previous slides for these.

a. What is the optimal utility?

100
𝜐 1,1,100 = =50=initial utility
2 1∗1
b. If price of good 1 increases to 1.1 Birr while price of good 2 and income
are unaffected, what is the new utility level?
𝑝1𝑎 = 1.1𝐵𝑖𝑟𝑟
100
𝜐 1.1,1,100 = =47.67=New utility level
2 1.1∗1
c. Compute the compensating variation
𝑚′
50 = → 𝑚′=104.88
2 1.1∗1
→CV=104.88-100=4.88 Birr
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 Welfare and Economic change CONT’D
Alternative way to calculate CV
𝑒 𝑝, 𝑢 = 2𝑢 𝑝1 𝑝2 (obtained by applying duality to Indirect Utility)
𝑝2
By Shephard’s Lemma, 𝑥1ℎ =𝑢
𝑝1

𝑝1=1.1 𝑝2
Hence, CV=‫𝑝׬‬ 𝑢𝑖 𝑑 𝑝1 = 2𝑢𝑖 𝑝1 𝑝2 | = 2 ∗ 50 ∗ 1[ 1.1 − 1]
1=1 𝑝1

=4.88Birr
Rule of integration
𝟏
(− +𝟏)
𝟏 𝑥 𝟐
‫׬‬ 𝒅𝑥 = ‫ 𝑥 ׬‬−𝟏/𝟐 𝒅𝒙= 𝟏 +c =2 𝒙+c
𝑥 (− +𝟏
𝟐

32
 Welfare and Economic change CONT’D
d. Compute the Equivalent variation
𝑚′
47.7 = → 𝑚′=95.4
2 1∗1

→EV=100-95.4=4.6 Birr
Alternative way to calculate EV
1.1
E𝑉 = ‫׬‬1 𝑥𝑖ℎ 𝑝1 , 𝑝2 , 𝑢𝑎𝑓𝑡𝑒𝑟 𝑑 𝑝1 =2𝑢𝑎𝑓𝑡𝑒𝑟 𝑝1 𝑝2 | = 2 ∗ 47.7 ∗ 1[ 1.1 − 1]
=4.6 Birr

e. Calculate the normal consumer surplus

This is to be calculated from the ordinary or Marshallian demand

𝑚
𝑥1 𝑝1 , 𝑝2 , 𝑚 = (Roy’s identity on 𝜐 𝑝1 , 𝑝2 , 𝑚 ) or by duality on 𝑥1ℎ
2𝑝1

1.1 1.1 𝑚 𝑚 1.1 1 100

CS = ‫׬‬1 𝑥1 𝑝1 , 𝑝2 , 𝑚 𝑑 𝑝1 = ‫׬‬1 𝑑 𝑝1 = ‫׬‬ 𝑑 𝑝1 = (ln1.1 − ln1)
2𝑝1 2 1 𝑝1 2
CS =4.75
Rule of integration
𝟏
‫ 𝐱𝐧𝐥 = 𝐱𝐝 𝐱 ׬‬+ 𝐜

Note that CS is between EV and CV. CS is an average of EV and CV.

33
 Welfare and Economic change CONT’D
f. Calculate the total price effect, SE and IE of the increase in 𝒑𝟏 from 1 birr to 1.1
Birr
𝑚
𝑥1 𝑝1 , 𝑝2 , 𝑚 = (Roy’s identity on 𝜐 𝑝1 , 𝑝2 , 𝑚 ) or by duality on 𝑥1ℎ
2𝑝1
100 100
𝑥10 = =50 and 𝑥12 = =45.45
2∗1 2∗1.1
→Total price effect (TPE) is 𝑥12 -𝑥10 =45.45-50=-4.55
𝑝2 1
-from the Hicksian demand function, 𝑥11 = 𝑢0 =50 =47.67
𝑝1𝑎𝑓𝑡𝑒𝑟 1.1
→SE=𝑥10 -𝑥11 =47.67-50=-2.33

→Income Effect=TPE-SE=-4.55-(-2.33)=-2.22

34
 Welfare and Economic change CONT’D
Alternative approach to TPE, SE and IE (Using Slutsky decomposition)
𝜕𝑥 ℎ 𝜕𝑥
𝜕𝑥 = ∗ 𝜕𝑝1 − ∗ 𝑥1ℎ * 𝜕𝑝1
𝜕𝑝1 𝜕𝑚
𝜕𝑥 ℎ −3Τ
SE = ∗ 𝜕𝑝1 =−0.5𝑢0 𝑝2 ∗ 𝑝1 2
=-0.5*50* 1 ∗ (1.1)−1.5 (0.1)=-2.88
𝜕𝑝1
𝜕𝑥 1 1
IE = − ∗ 𝑥1ℎ * 𝜕𝑝1 = -[ *47.67*0.1]=-[ *47.67*0.1]=-2.16
𝜕𝑚 2𝑝1 2.2

TPE=-2.88-2.16=-5.04→increase in price of good 1 decreased the total

quantity demand of good 1 by 5.04 units
** slightly different results in the SE in the two methods is due to rounding

35
 Welfare and Economic change CONT’D

Practice question
Suppose the consumer’s utility is given by 𝑢 = 2 𝑥 + 𝑦

Consumer’s income is 100 and 𝑝𝑥 = 1 𝑎𝑛𝑑𝑝𝑦 = 1

Solve the effect of a price change on consumer welfare using the three
methods if 𝑝𝑥 increase to $2.

36
 Insights in to Behavioural Economics
• Do the axioms always hold?
• Are consumers truly rational?
• Too many choices/much information;
• Are consumers always attentive?
• Are consumer choices consistent?
• What about the Present biased nature of consumer Preferences
• Behaviour is influenced by our environment and the information
we have – Poor feedback restricts information.

37
 Behaviour Insights

Can behavior be influenced to become more rational?

38
Chapter Closure

39
 Recall the discussion at the beginning of the course:
How will you benefit from this course?

Where does microeconomic theory fit in contemporary

economic research?
(Tilman Börgers:2022)
American Economic Review:Vol. 113 No. 10,October 2023
• Hard to guess what some of these articles
are about?
• Variety of topics
• Economics is divided into many fields
• Demand for Government: Public good
provision
• Regulation and competition
• Behavioral economics
• Development Economics/Female schooling
and employment
• Information Economics
• Migration/refugees
• Mechanism Design
• Trade and Industrial Economics
Let us focus on Lashkaripour and Lugovskyy (2023):
• Analyze optimal trade/industrial policy

• How large are the gains from terms-of-trade (ToT) manipulation?

• More simply put they study the impact of import tax, export tax,
production tax and consumption tax.

• Using micro level data one of their findings suggest: Corrective domestic
taxes deliver greater gains than foreign trade taxes for most economies
Lashkaripour and Lugovskyy (2023): Excerpt from
the section : Theoretical Framework
 Empirical Applications: AIDS and QUAIDS
• A two-stage Quadratic AIDS (QUAIDS) model is used to compute coefficients and
calculate the demand elasticity's. In this model assumption of linearity in the expenditure
function is given away.

• Almost Ideal Demand System (AIDS) budget equation

– was first introduced into economic literature by Deaton and Muellbauer (1980).
– https://www.jstor.org/stable/pdf/1805222.pdf?refreqid=excelsior%3A8072093276c67
9d8487e8337ca29febc
– AIDS model has the following form:

44
Empirical studies in Ethiopia

45
 AIDS cont’d
• AIDS is a derivation of the price independent generalized logarithmic (PIGLOG)
cost function which is defined as follows
• log 𝑒 𝑝, 𝑢 = 1 − 𝑢 𝑙𝑜𝑔 𝑎(𝑝) + 𝑢𝑙𝑜𝑔 𝑏(𝑝) , 𝑤ℎ𝑒𝑟𝑒 𝑢 ∈ (0,1)
1
𝑙𝑜𝑔𝑎(𝑝) = 𝛼0 + ෍ 𝛼𝑘 𝑙𝑜𝑔𝑝𝑘 + ෍ ෍ 𝛾𝑘𝑗 𝑙𝑜𝑔𝑝𝑘 𝑙𝑜𝑔𝑝𝑗
2
𝑘 𝑘 𝑗
𝛽𝑘
𝑙𝑜𝑔𝑏 𝑝 = 𝑙𝑜𝑔𝑎 𝑝 + 𝛽0 ෑ 𝑝𝑘
𝑘
• Since 𝑢 lies between 0 (subsistence) and 1 (bliss), 𝑎(𝑝) and b(𝑝) can be regarded as
the costs of subsistence and bliss (luxury), respectively
• Based on this specification the
1 𝛽
log 𝑒 𝑝, 𝑢 = 𝑙𝑜𝑔𝑚 = 𝛼0 + ෍ 𝛼𝑘 𝑙𝑜𝑔𝑝𝑘 + ෍ ෍ 𝛾𝑘𝑗 𝑙𝑜𝑔𝑝𝑘 𝑙𝑜𝑔𝑝𝑗 + 𝑢𝛽0 ෑ 𝑝𝑘 𝑘
2
𝑘 𝑘 𝑗 𝑘

46
 AIDS cont’d
• Deriving both sides with respect to 𝑝𝑖
𝜕𝑙𝑜𝑔𝑒(𝑝,𝑢) 𝜕𝑒(𝑝,𝑢) 𝑝𝑖 𝑝
LHS: = = 𝑥𝑖 𝑖 = 𝑤𝑖 (budget share of good i)
𝜕𝑙𝑜𝑔𝑝𝑖 𝜕𝑝𝑖 𝑒(𝑝,𝑢) 𝑒(𝑝,𝑢)
𝝏𝒆(𝒑, 𝒖)
= 𝒙𝒊 (𝐒𝐡𝐞𝐩𝐡𝐚𝐫𝐝𝐬 𝐋𝐞𝐦𝐦𝐚)
𝝏𝒑𝒊
𝛽
RHS: 𝛼𝑖 + σ𝑘 𝛾𝑘𝑗 𝑙𝑜𝑔𝑝𝑘 + 𝑢𝛽0 𝛽𝑘 ς𝑘 𝑝𝑘 𝑘
𝛽
→𝑤𝑖 = 𝛼𝑖 + σ𝑘 𝛾𝑘𝑗 𝑙𝑜𝑔𝑝𝑘 + 𝑢𝛽0 𝛽𝑘 ς𝑘 𝑝𝑘 𝑘
After replacing the observable utility by the indirect utility function the following is
obtained
𝑤𝑖 = 𝛼𝑖 + ෍ 𝛾𝑘𝑗 𝑙𝑜𝑔𝑝𝑘 + 𝛽𝑖 log(𝑚/𝑝)
𝑘
1
Where log 𝑝 = 𝛼0 + σ𝑘 𝛼𝑘 𝑙𝑜𝑔𝑝𝑘 + σ𝑘 σ𝑗 𝛾𝑘𝑗 𝑙𝑜𝑔𝑝𝑘 𝑙𝑜𝑔𝑝𝑗
2

47
 AIDS Cont’d
• Parameter restrictions for mathematical construction
• σ𝑖 𝛼𝑖 = 1, σ𝑖 𝛽𝑖 = 0, σ𝑖 𝛾𝑖𝑗 = 0, σ𝑖 𝛾𝑖𝑗 = σ𝑖 𝛾𝑗𝑖
• Application using data
https://journals.sagepub.com/doi/pdf/10.1177/1536867X150
1500214
webuse food
drop lnp1 lnp2 lnp3 lnp4 lnexp
aidsills w1-w4, prices(p1-p4) expenditure(expfd) symmetry
alpha_0(10)
outreg2 using k.doc, replace
 (1) (2) (3) (4)
VARIABLES w1 w2 w3 w4
gamma_lnp1 0.123*** -0.0546*** -0.0352*** -0.0332***
(0.00594) (0.00459) (0.00238) (0.00466)
gamma_lnp2 -0.0546*** 0.0680*** -0.00124 -0.0121***
(0.00601) (0.00463) (0.00240) (0.00468)
gamma_lnp3 -0.0352*** -0.00124 0.0426*** -0.00611*
(0.00448) (0.00344) (0.00179) (0.00349)
gamma_lnp4 -0.0332*** -0.0121*** -0.00611*** 0.0515***
(0.00469) (0.00366) (0.00188) (0.00369)
beta_lnx 0.0158*** -0.0261*** 0.00138 0.00893***
(0.00343) (0.00262) (0.00138) (0.00270)
alpha_cons 0.395*** 0.141*** 0.111*** 0.353***
(0.0224) (0.0171) (0.00900) (0.0176)

Standard errors in parentheses, *** p<0.01, ** p<0.05, * p<0.1

• Expenditure share of goods increases with own price and decreases with other
goods price
• Coefficient of beta_lnx indicates that good 2 is inferior whereas the others are
normal goods.

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• The post estimation command aidsill_elas gives the predicted shares, and
elasticities (budget and price elasticities) with their standard errors.
• Other applications
– Expenditure based measurements of food and absolute poverty
– Expenditure based measurements of welfare and so on.

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