Consumer Surplus: The Triangle-like area behind the

demand curve and above the price line.

Two most important WTP measures are compensating
and equivalent variations.
Compensating Variation: the amount of money which
taken away from an individual after an economic change
leaves the person just as well off as before.
Equivalent Variation: the amount of money paid to an
individual which, if an economic change does not happen,
leave the individual just as well off as if the change had
occurred.
 WILLINGNESS TO PAY
Compensation variation in its WTP interpretation
measures the maximum amount of income the
consumer is willing to pay for a change in prices, and
order in which prices are reduced cannot affect this
amount.
To calculate compensating or equivalent variation , the
Hicksian compensated demand curves used rather
than ordinary demand curves.
In compensated demand curves, utility level used while
in ordinary demand curves, income level used.
The single Price Change Case
CALCULATE COMPENSATION AND
EQUIVALENT VARIATION
Income elasticity is given below;
=q/ m.m/q
q= .q. m/m
m=S
q= .q. S/m
area b= q.| p|= . S.q. | p|/m

S=q| p| for small p. Hence ,the

compensating variation (C=area a) can b
approximated by subtracting the forgoing
approximation of area b from area a+b (= S )
CONSUMER SURPLUS AS A WTP MEASURE: THE
MULTIPLE-PRICE CHANGE CASE:-
Prices are p10 and p20 for
commodities q1 and q2
and that prices change to
p11 and p21 respectively.
Changing p1 first and
then p2.
 COMPENSATING AND
ORDINARY DEMAND
CURVE
H1(p02,UO)is
compensating demand
curve and D1(p02 , m0 ) is
ordinary demand curve .
Demand curves are
distinguished on utility
level rather than income
level.
Consumer surplus S1 ,is
area a+b.
The compensating
variation associated with
this part of the path, C1, is
area a.
Calculation of compensation and
Equivalent variation
CONSUMER SURPLUS AS A WTP MEASURE:
THE PRICE-INCOME-CHANGE CASE
 The figure in the above slide show that change in
price and incom.
First income change (L1) and then price change
(L2).
Utility level change with change in price.
Thus compensating variation corresponding to the
price change must be added to the subsequent
WTP for the income change, which continue hold
utility at the overall initial level.
On the other hand ,if one first changes income
thus generating compensating variation equal to
the change in income , the level of utility at which
the price change segment of the path begins is
different from the utility level.
 In evaluating compensating variation for the
priceincome change case only if the income
change is considered after the price change.
In the case of equivalent variation the
price change(s) must be considered after the
income change, so that the terminal utility of the
pricechange segment of the path is the same as
the terminal utility level of the overall price
income change.
APPLICATION OF THE ABOVE SLIDE
ARGUMENT GRAPHICALLY IN THE FIGURE
 The above figure explain that income and a single
price changes from (m0,p10) to (m1,p11),
respectively.
The ordinary and compensated demand curves
are D(m0) and H(U0), respectively, and
subsequently change to D(m1) and H(U1),
respectively.
U0 is the initial utility level, U1 is the subsequent
utility level, and U0* is the utility level after the
income change but before the price change.
ESTIMATION OF COMPENSATING VARIATION
H(U0) is the appropriate compensated demand
curve (it is conditioned on the initial utility level ),
the compensation variation is;
C=m1-m0+area a
Area a is estimated by correcting the change in
consumer surplus, area a+b, associated with D(m0)
by an estimate of area b.
Change in surplus, area a+b+c+d, associated with
D(m1) .
 The correction approximates area d and gives a
resulting estimate of area a+b+c.
The associated estimate of compensating
variation would approximate (area
a+b+c)m1+m0 and would be in error by
approximately area b+c.
Thus, to estimate compensating variation one
must evaluate the effects of the price change at
the initial income level and then add to that
effect the change in income.
 ESTIMATION OF EQUIVALENT VARIATION
To estimate equivalent variation, one must evaluate
the effects of the price change at the terminal income
level and then add that effect to the change in income.
U1 represent the terminal level of utility.
Both the price and income segments of the path of
adjustment are properly evaluated at the terminal
utility level.
the change in area behind the terminal compensated
demand curve, area a+b+c+d+e, is obtained by adding
an estimate of area e to the surplus change, area
a+b+c+d, associated with the ordinary demand curve
conditioned on the terminal income.
 EXACT MEASUREMENT OF WTP
As the Willig approach suggests, ordinary demand
relationships can be used to derive information about
Hicksian compensated demands by using the information
they contain regarding response to income changes. This
information can be used to infer Hicksian demands and the
related exact measurements of compensating and equivalent
variation. This approach eliminates the need to rely on
consumer surplus as an approximation of WTP measures.
This possibility was first suggested by Hause (1975) and later
demonstrated more generally by Hausman (1981) with a
somewhat different approach.
EXACT MEASUREMENT OF WTP
Vartia (1983) developed an algorithm to solve the
multiple-equation differential equation problem
associated with multiple price changes numerically.
 price change from p0 to p3 is imposed in
incremental changes first to p1 then to p2 and
finally to p3. Initially, income is m0 and utility is
U0 with Marshallian demand D(m0) and Hicksian
demand H(U0). The compensating variation of
the first price change to p1 is given by area a0
which, for small price changes, is approximated
by the consumer surplus change, area a0 + a1.
Next, this money measure of welfare change is
subtracted from initial income m0 to obtain
income m1 and demand D(m1).
 The same procedure is then repeated for the price
increment to p2 by subtracting area b0+b1 (as an
approximation of area b0) from m1, obtaining m2 and an
approximation of D(m2), which again restores the initial
utility level.
The procedure is repeated again until the subsequent
price p3 is reached by subtracting area c0+c1 (as an
approximation of area c0) from m2 to obtain m3, which
aside from an approximation error restores the initial
utility level once more.
 The approximation of compensating variation for
the entire price change from p0 to p3 is thus m3-
m0= area a0+a1+b0+b1+c0+c1. The error of
approximation is a1+b1+c1.
The overall price change is broken into many
small changes the estimate converges to the true
compensating variation, area a0+b0+c0 because
the error triangles become smaller.
Thanks