Measuring the contributions of productivity and terms of trade to Australia's economic welfare Book

The paper discusses the problems of measuring welfare changes brought about by large price increases or decreases, such as occur in the power sector when tariffs are raised to cover long-run costs, or when electrification displaces more expensive alternatives. In the evaluation of such projects, traditional methods of measuring these welfare changes have centered on the use of the consumer surplus. This measure is known not to be ideal but is usually justified on the grounds that it will be a close approximation to exact measures of welfare change (the equivalent and compensating variation). The paper points out that consumer surplus is known to be a close approximation of exact measures only when income elasticities are low and when relatively small price changes are being analyzed. Because the demand for electricity typically has very high income elasticities for countries with low levels of income, and because it is in just such countries that the very large price shifts occur, the paper argues that consumer surplus is in such cases an unreliable measure of the welfare impacts of these price changes. Numerical calculations are carried out illustrating the degree of inaccuracy that can be involved in using consumer surplus as a measure of welfare changes. As an alternative to using the consumer surplus, the paper shows how the compensating or equivalent variations in income can be calculated whenever the demand curve is available, using Vartia's algorithm. The paper also illustrates how these calculations can be carried out using a simple spreadsheet approach. Finally, other methods of approximating the equivalent variation and compensating variation are discussed; it is shown thatthese should be avoided and Vartia's exact calculation utilized, unless the demand curve is unknown.