Suppose that consumer has utility function U(X1, X2)=X½,X½. He originally face price (1,1) and has income 100. Then the price of good1 increase to 2. What are the compensating and equivalent variation?
Compensating Variation: The compensating variation is the amount of money the consumer would need to be given in order to be as well off as he was before the price change. In this case, the compensating variation would be 50.
Equivalent Variation: The equivalent variation is the amount of money the consumer would need to be given in order to be as well off as he would have been if the price had not changed. In this case, the equivalent variation would be 25.