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)Explain and find the compensating and equivalent variation?
Compensating variation (CV) is the amount of money that a consumer would need to be given in order to be as well off as before the price change. Equivalent variation (EV) is the amount of money that a consumer would need to be given in order to be as well off as if the price change had not occurred.
Compensating variation = 100 - (2^0.5/2^0.5) = 100 - 2 = 98
Equivalent variation = 100 - (2^0.5/1) = 100 - 2^0.5 = 97.32