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CV and EV

The document defines and provides examples of compensating variation and equivalent variation using utility functions and indifference curves. Compensating variation is the amount of money needed to compensate a consumer for a loss of well-being due to a price increase. Equivalent variation is the amount of income reduction that results in the same loss of well-being as that caused by a price increase. The document illustrates these concepts using Cobb-Douglas and quasi-linear utility functions, showing how to calculate the compensating and equivalent variations algebraically for price changes using optimization of the utility functions.

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Saman Naqvi
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529 views6 pages

CV and EV

The document defines and provides examples of compensating variation and equivalent variation using utility functions and indifference curves. Compensating variation is the amount of money needed to compensate a consumer for a loss of well-being due to a price increase. Equivalent variation is the amount of income reduction that results in the same loss of well-being as that caused by a price increase. The document illustrates these concepts using Cobb-Douglas and quasi-linear utility functions, showing how to calculate the compensating and equivalent variations algebraically for price changes using optimization of the utility functions.

Uploaded by

Saman Naqvi
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOC, PDF, TXT or read online on Scribd
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Compensating and Eqivalent Variations

Compensating Variation: how much money should we give the consumer in order to compensate her for the reduction in her well-being due to an increases in the price of a good? This amount of money is called the compensating variation in income. Note that we may not actually pay the consumer any money, we are just trying to find a monetary measure of a loss in well being. Look at Figure 1. Suppose the consumer is initially at point A. Then the price of good 1 increases and the BL rotates and becomes blue. The consumer is worse off since she moves to a lower IC. How much money should we pay her to bring her back to her initial IC. In other words, how much money should we pay her to shift her BL to the green position? This amount of money is called compensating variation.

Figure 1

A B

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Equivalent Variation:

This is the reduction in consumer income that results in a reduction in well being that is equaivalent to a loss of well being resulting from a price incresae. Look at Figure 2. If the price of good 1 increases, the consumer will move from bundle A to B and will become worse off. If instead of this price change, we had taken away some income from the consumer and as a result the consumer had moved to the same indifference curve, that amount of income would have been called the equivaelnt variation.

Figure 2
Equivalent Variation

A B C

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Algebra of Compensating and Equivalent Variations: Cobb-Douglas Utility Functions Suppose we have: U = X1.8X2.2 M = $100 P1 = $2 P2 = $4 Therefore, X1* = .8 100/2 = 40 X2* = .2 100/4 = 5 These are point A in Figure 8. Now P1 to $4. If we dont do anything, the consumer will move to point B in Figure 8. She will be worse off because she will be on a lower IC. How much money should we pay the consumer to compensate her for this price increase? Well, what is her utility at the initial bundle (point A)? U = (40).8(5).2 = 26.40 If we give her some money to raise her income to M, how much will she consume at the new prices? X1* = .8 M/4 X2* = .2 M/4 We want this new bundle to give the consumer the same amount of utility as the initial bundle. So U = (.8 M/4).8(.2 M/4).2 = 26.40 or M(.15) = 26.40 M = 174.11 So the compensating variation is: M - M = 174.11 - 100 = $74.11 Now the equivalent variation: As a result of the increase in the price of good 1 to $4 the consumers optiomal bundle becomes X1* = .8 100/4 = 20 X2* = .2 100/4 = 5 So her utility becomes Page 3 of 6

U = (20).8(5).2 = 15.16 Now, what level of income with the old prices would give the same amount of utility? Let this level of income be M. Then U = (.8M/2).8(.2M).2 = 15.16 M=57.43 So the equivalent variation is 100 - 57.43 = $42.57 Note in graphing that in the above cases when P1 changes, this change only affects X1 and not X2. See Figure 10 below for the compensating vartaion. The case of equivalent variation is similar. This is because of the nature of the utility function. If we had a different utility function, we would get a different result. Compensating and Equivalent Variation: Quasi-Linear Utility Functions A consumer has the following utility function: u = 2x10.5 + x2 (Quasi-Linear Utility Function) Assume that initially m = $100, p1 = $2, and p2 = $10. Then p1 increases to $5. Find the CV and EV.

u =1 x 2 1 u x x 1 MRS = 1 = 1 = u 1 x1 x 2 1 x1 = p1 p2 (MRS = Slope of budget line)

From this we find:


p 10 x = 2 = = 25 Plug this in the budget line to get: p 1 2
* 1 2 2

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p p1 2 + p 2 x 2 = m p 1

x* = 2

m p 2 100 10 = = 5 (verify this) p 2 p1 10 2


.5

u * = 2( 25 ) + 5 = 15

Now let p1 = $5. Increase consumer income to m such that with the new price the consumer can reach u* = 15.
10 *' x1 = = 4 5
2

x *' = 2

m' 10 m' = 2 10 5 10
.5

u * = 2( 4 ) + m' = 130

m' 2 = 15 10

VC= 130 100 = 30 Now EV:


10 x = =4 5 100 10 * x2 = =8 10 5 u * = 2( 4) .5 + 8 = 12
* 1 2

How much income should we take away from the consumer so that at the old prices the consumer reaches u*= 12?
u * = 2(25) .5 + m' 10 = 12 10 2

so, m = $70 and EV = 100 - 70 = 30, same as CV.

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Figure 3

A B

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