Advise on the changes in citizens’ welfare caused by the increase in university fees, considering the resultant partial switch from public to private funding of university education. Citizen Welfare can be measured using several economic forms of analysis. The current controversy over the introduction of top up fees have led people to evaluate the effective increase in consumer prices. Any change in policy can have both good and bad effects on different groups of society.
For many problems in society, we wish to observe the effects of a policy change and its repercussions on the welfare of society. In this paper I will attempt to discuss the result of an increase in university fees by examining the Marshallian and the Hicksian measures of consumer surplus. I will consider the differences in analysis and the outcome of applying them to the situation. In the situation of an increase in fees, we are essentially looking at an increase in price. The diagram below shows a monetary loss due to the increase in price from p1 to p2.
Students are now paying more for their tuition they are consuming. After the price increase the student moves from x1 to x2 at a new higher price of p2. Each unit of education is now more expensive by an amount of (p2 – p1). The result of this means that the student now has to pay (p2 – p1)x2 more money than before. 1 Due to the increase in price, the student is cannot afford as much education, therefore the triangle T represents the consumption loss and R represents the loss due to having to pay higher tuition fees.
Looking at this model it is clear to see that an increase in price leads to a loss of welfare as the consumer is forced to have less than originally wanted. Consumer surplus is a nice way of demonstrating the change in welfare, but for some measures, such an approximation may not be suitable. Alternatively we can look at ways to measure utility changes. We can estimate utility by observing consumer choices and also by measuring it in monetary units. Here we are looking at how much we would have to compensate a consumer for a change in his/her consumption patterns.
Here we are going to look at the compensating and equivalent variations. In the case of an increase in tuition fees, the consumer (student) initially faces the tuition fees at price () and consumes the bundle (). The price of tuition fees increases from to , and the consumption changes to (). From this we can try and evaluate what effect this price change has on welfare of the student. The amount of compensation required to keep the student as well off as before the price change is one way of finding the answer.
In the diagram we ask how far we would have to push the budget line in order to become tangential to the initial indifference curve at the original point (). The change in income that is required to compensate the student for the price change is called the compensating variation and is shown by CV on the diagram. This amount is what the government would have to pay in order to keep the students at exactly the same level. In reality, the government is doing the exact opposite.
They are privatising tuition fees, meaning that students will no longer be compensated and will be forced to pay much higher prices. In other words, it is the amount of wealth taken away in order to keep the individual at the same utility level with new prices and old utility. Therefore, the value CV shows the welfare loss of the students. 2 The other measure to look at is the equivalent variation. This looks at the amount of money that would have to be taken away from the consumer before the price change to leave him/her as well off as after the price change.
It is the income change that is equivalent to the price change in terms of the change in utility. Here, EV measures the maximum amount that the student will be willing to pay in order to avoid changing their utility level, ie remain indifferent in terms of their received education. In other words, it is the amount of money the consumer would be indifferent in lieu of a price change, leaving them at a new utility with old Prices. 3 After establishing what the different measures of consumer welfare are, we can now begin to evaluate their differences.
Normal Marshallian demand curves include both substitution and income effects. If the price of a normal good x increases from P0 to P1, consumers buy less of it because their purchasing power is less, so they are forced to buy less of everything, and also they substitute what they buy for items which are less expensive. The substitution effect is “utility-neutral” since it implies a movement along the same indifference curve; the income effect implies a jump to what would be a lower level of utility, and thus quantifies the welfare loss resulting from the price decline.
Income-compensated Hicksian demand curves reflect just the substitution effect. The income effect is removed by adjusting the consumer’s budget so that the ex ante and ex post utility levels are the same. In the context of a price increase, the compensating variation is the income adjustment that leaves the consumer at the old utility level under the new price: U0(P0,M) = U0(P1, M-CV). Graphically, this is the area behind the compensated demand curve associated with initial utility. 5 EV is the utility-neutral measure based on the consumer’s ex post level of utility U1.
Graphically, this is represented as the increase in the area behind the compensated demand schedule associated with the new utility. 6 Graphically we can represent the three different measures of welfare. EV and CV can be operationalized through the concept of consumer surplus. Since EV and CV are grounded by individual preferences the concept of consumer surplus is meaningful. The Hicksian demand is steeper than the Marshallian Demand because it only accounts for substitution effects whereas Marshallian Demand focuses on income and substitution effects.
In the graph above, CV is region A, EV is region A+B+C, and the change in consumer surplus is equal to A+B. CV is how much the area under the Hicksian demand changes and the EV is how much the area changes at the new utility. Therefore consumer surplus lies in the middle of CV and EV. 7 With a price decrease: CV;consumer surplus;EV With a price increase: CV;consumer surplus;EV8 If there is a small income effect, the difference between the Hicksian and the Marshallian demand is small and the difference between CV, EV and consumer surplus is small.
So having looked at the differences between the different measurements, we now have to decide which measurement is most appropriate, and establish what the final effect of the increase in tuition fees is going to have on all citizens, not just students as we have looked at so far. When determining which measures to use you simply have to “use what you can”9. If we are measuring a change which has already occurred then equivalent variation should be used. When looking at a change that may occur in the future, then CV should be used (people do not know what their change in utility will be before they have actually experience it)10.
If actual changes in expenditure function are complicated to come by, then consumer surplus should be used. Real market data may have the advantage of being less ‘noisey’ than other data needed for more exact measure. We cannot use utility because it is an ordinal concept. CV and EV concepts rely on knowledge of the indifference map. If we do not have that, we may instead use the demand curve to develop a monetary measure of consumer welfare. Consumer surplus is more practical because the Marshallian Demand is easier to measure; prices and income are observable.
The Hicksian Demand is based on utility which is hard to measure. Although we have looked at the different measurements of welfare, so far it has only been to show how a student’s welfare would change with a change in price of fees. By looking at a simple budget constraint for the government as shown below, we can look at a simple model between what is essentially the welfare of students and all other citizens. If our initial spending on university tuition is and we then move to , then the government spending moves up and left so that spending on other citizens increases.
So with a reallocation of money by privatising the payment of tuition fees, it opens up new funds to be distributed for the benefit of the rest of society. From this simple model we can clearly see that the welfare of the rest of society has increased. It might be argued that the proportion of the population receiving benefits is much larger at (,) as it is affecting more people. Then again, we are not specifying which groups in society receive funds. Also, one might argue that the specific purpose of public spending is far more beneficial in the long run.
In this paper, I have looked at the different techniques of measuring welfare and established that the use of the traditional Marshallian demand curve is suitable and most practical. At the same time, I have shown that by increasing the cost of tuition fees, students are losing welfare. But at the same time, there is a tradeoff with the rest of society and we can see a welfare gain for them.
Hal R. Varian, (1999) Intermediate Microeconomics, 5th ed. , W. W. Norton & Company. Arthur T. Denzau, (1992) Microeconomic Analysis, 1st ed. , Richard D. Irwin, Inc. , 1992 Ronald Shone, Applications in Intermediate Economic.