A basic problem with policy evaluations and social welfare functions based on individual utility functions is that these functions are unobservable. There is no direct way we can observe how much a household gains from, for example, a fall in a commodity price. We need indirect measures that correctly reflect changes in welfare. One way to obtain such measures is by collecting information on consumers' actual behaviour in markets for goods and services. In this chapter, we will review the literature on the measurement of welfare (change). The chapter also includes a presentation of how information about a firm's supply and demand curves can be used to calculate changes in profits or producer surplus.

Consumer surplus

Consider a commodity such as bottles of wine that is bought in integers (0, 1, 2, etc., units). Let us further assume that the price of the commodity is subject to large variations over time (but all other prices and the consumer's income are assumed to remain constant over time in order to simplify exposition). In figure 4.1a we have depicted a consumer's observed demand for the commodity as a function of its price. If the price exceeds $10, the consumer refrains from buying the commodity at all. The consumer's preferences are apparently such that he does not find one unit of the commodity worth a price of more than $10; he prefers to spend his limited income on other commodities. Now suppose the price is reduced to $10. Then the consumer in figure 4.1a will be indifferent between buying one unit of the commodity and spending these dollars on other desired commodities.