Question

Define the concepts: maximum Willingness to Pay (WTP), minimum Willingness to Accept Compensation (WTA). In your definitions, explain these concepts of compensating variation and equivalent variation. Explain their relevance in terms of property rights assumed in environmental policy decisions. Are these concepts equal? How are these related to consumer surplus?

Answer 1

Maximum Willingness to pay is generally asked due to the fact that the concerned party wants to avoid a decrease in the quality of environment. willingness to pay (WTP) and willingness to accept (WT A) represent the two
general measures of economic value for an environmental service. an individual's concept of the willingness to pay for environmental quality is a rational choice made by the consumer .

we assume that the environmental damages have an impact on consumer and for this we need to look at the mometary aspect of the damages . given a consumer's demand function , we can look at the consumer's surplus. it decreases when the monetary aspect of the utility of a consumer changes. like when the price of a good the consumer consumes increases we see that the consumer surplus reduces.

now we look at the hicksian measure of utility change and price change .

the compensating variation refers to the cahnge in income which is seen as the compensation due to cahnge in prices.it leaves the individual at his initial level of utility. so it is the maximum amount that the individual would pay to
have the price fall occur.

and equivalent variation (EV) is change that is done in income which is equivalent to the change that would occur in prices in future.EV is the minimum compensation that the individual would accept in lieu of the price fall when it happens.

so in a way CV is the maximum willingess to pay and EV is the minimum willingness to accept the compensation when price falls and when price rises CV is the minimum willingness to accept the compensation and EV is maximum willingess to pay .

The Marshallian demand function shows how the quantity of good 1 demanded varies with price of good 1, when the
consumer’s income and all other prices are held constant.(ceterus paribus ). A Hicksian demand function is the relationship between the quantity demanded of a good and the price of that good, holding all other prices and
utility constant. This distinction is required when we look at the CV and EV with respect to Marshallian consumer surplus or MCS.

When the income elasticity of demand for the good is zero, then the Hicksian demands become identical to the Marshallian demand function, and so EV = CV = MCS. The reason for this is that the income effect of the price change is zero.

In other cases we have

when the price falls then

CV<MCS< EV ie the willingness to pay is less than the consumer surplus and the willingness to accept compenstion is more than the surplus.

so we have WTP<MCS< WTAC

then the opposite case happens when the price of good increases .

EV<MCS<CV which ,means that in this case too WTP<MCS<WTAC

only in the special case we see that MCS=EV=CV as in when the income elasticity of demand for the good is zero.