Please explain this step by step please, I am not getting it
VI 13 D D U: L. ll) :5 C) 10 Use of recreation area (hrs/wk) FIGURE 6.20 The Willingness to Pay for and Accept the Loss of :1 Recreation Area Initially the consumer is at point A. If the recreation area is closed then he will move to point D. If the consumer is given an extra 40/wk he remains on his initial indifference curve and so 40/wk is his willingness to accept the closure of the recreation area. If the recreation area remains open but the consumer only has 70/wk then he will be on the same indifference curve as if the recreation area is closed. So, 3 Ofwk is his willingness to pay to avoid closure of the recreation area. Recall that compensating variation measures the amount of money a person would be willing to accept to avoid a price rise. In gmj we see that the consumer would be willing to accept (WTA) 40/wk for the loss of the recreation area. Specically, spending 140/wk on goods and consuming 0 hrs/wk of the recreation area would leave him on the same indifference curve, 10, as currently. The WTA of 40/wk is one measure of the welfare loss from closing the recreation area. Similarly, recall that the equivalent variation measures the amount of money a person would be willing to pay to avoid a price rise. In Ligm Q10 we see that the consumer would be willing to pay (WTP) 30/wk to avoid losing the recreation area. Specifically, spending 70/wk on goods and consuming 10 hrs/wk in the recreation area would leave him on the same indifference curve, [1, as if the recreation area were not available. The WT P of E3 0/wk is another measure of the welfare loss from closing the recreation area. For a normal good the willingness to accept the loss of a good will be greater than the willingness to pay, just as the compensating variation of a price rise is greater than the equivalent variation. The difference should, Equivalent variation w 5J1 U'I o I\" N U'I 3'; E \\u- 1'? O O U\": L. Q) '5 O 45 60 70 80 Petrol (litres/wk) FIGURE 6.19 The Equivalent Variation of a Petrol Price Increase The consumer would be willing to pay up to 39.38 to avoid the tax increase. This would leave him at least as well off as if the tax increase went ahead and resulted in him being on indifference curve I]. The equivalent variation of 39.38/wk compares to the previously calculated compensating variation of 46.88/wk and change in consumer surplus of 43. 14/wk. All three are measures of the welfare loss from the tax increase. Which measure should we use? This will depend in large part on the specics of the situation. If the revenue raised from the tax will likely nd its way back, through government spending, to the people who pay the tax then the compensating variation would seem more appropriate. By contrast, if the revenue raised will likely not nd its way back to the people who paid it then the equivalent variation seems more appropriate. Note that if income effects are small then all three measures will be very similar. In measuring equivalent variation we perform the thought experiment of asking how much a consumer would pay to avoid a tax. Society does, however, face a very real choice between raising revenue through income taxes or through taxes on goods and services (other than labour). With this in mind, let us calculate how much revenue the government would raise in the petrol tax example. If the price of petrol increases to 1.50 and the consumer reduces his consumption of petrol to 45 litres/ wk (point D in M) then the government would raise (1.50 0.75)(45) = 33.75/wk extra revenue. Recall, however, that the equivalent variation was 639.3 8/wk. So the consumer would voluntarily pay, say, 63 8/wk in extra income tax if that meant a tax on petrol was not needed. This suggests that an income tax is the better deal. And indeed, taxes on labour are considerably higher than those on most other goods and services in European countries. But why tax goods and services at all if an income tax raises more revenue? First, as we shall see in W, a tax on labour distorts incentives to work and that can have negative consequences for efficiency. Also, there are certain goods like alcohol and petrol, the consumption of which can impose social costs on others. Such goods are often heavily taxed to reduce consumption to a more efcient level (see ChapteLl). Willingness to Pay and Accept Compensating and equivalent variation measure the change in welfare that results from a change in prices. It is a simple matter to extend this approach in order to measure the welfare consequences of more general changes in the opportunity set facing a consumer. Suppose, by way of illustration, that the government plans to ban the use of petrol in cars. Or, to give a slightly more realistic example, suppose that there is a proposal to build houses on a well-used recreation area. In both cases the policy would constrain consumers to have zero of the relevant good, either petrol or use of the recreation area. How can we measure the welfare consequences of this? EignerGJ depicts the situation in the recreation area example. Currently the consumer is at point A, spending 100/wk on goods and consuming 10 hrs/wk of recreation. Note that the price of using the recreation area (in this example) is zero and so the budget constraint is a horizontal line. If houses are built on the recreation area then the consumer will move to point D in EignZ where he still has 100/wk to spend on goods but now consumes 0 hrs/wk in the recreation area. Note that the price of using the recreation area has essentially become innitely large and so the budget constraint is now a vertical line
