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.
a)Evaluate compensating and equivalent variation?
Compensating Variation: The compensating variation is the amount of money that the consumer would need to be given in order to be as well off as before the price change. In this case, the compensating variation would be 50, since the consumer would need an additional 50 units of income to purchase the same amount of goods as before the price change.
Equivalent Variation: The equivalent variation is the amount of money that the consumer would need to be given in order to be as well off as if the price had not changed. In this case, the equivalent variation would be 100, since the consumer would need an additional 100 units of income to purchase the same amount of goods as if the price had not changed.