CV_vs_EV

# CV_vs_EV - ± CV ± EV If the demand for good 1 is inferior...

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Compensating vs. Equivalent Variation Notation: p 0 old price vector p 1 new price vector u 0 old level of utility u 1 new level of utility Indirect utility at old prices vp 0 , w () = u 0 Indirect utility at new prices vp 1 , w () = u 1 For simplicity, assume that only the price of good 1 changes from p 1 0 to p 1 1 . p ± 1 denotes all prices other than p 1 , which are assumed to stay constant. Compensating Variation (CV) Equivalent Variation (EV) Algebraic Definition CV = ep 1 , u 1 () ± ep 1 , u 0 () = ep 0 , u 0 () ± ep 1 , u 0 () = w ± ep 1 , u 0 () = h 1 s , p ± 1 , u 0 () s = p 1 1 p 1 0 ² ds EV = ep 0 , u 1 () ± ep 0 , u 0 () = ep 0 , u 1 () ± ep 1 , u 1 () = ep 0 , u 1 () ± w = h 1 s , p ± 1 , u 1 () s = p 1 1 p 1 0 ² ds vp 0 , w () = vp 1 , w ± CV () vp 0 , w + EV () = vp 1 , w () In the case of a price drop or subsidy (i.e. a negative tax): Compensating Variation (CV) Equivalent Variation (EV) Thought Experiment What is the maximum the consumer would be willing to pay to get the price drop or subsidy? How much would the consumer be willing to accept in lieu of the price drop or subsidy? Normal Good Normal Good Graphs Inferior Good Inferior Good Magnitudes/ Signs If the demand for good 1 is normal: 0

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Unformatted text preview: ± CV ± EV If the demand for good 1 is inferior: 0 ± EV ± CV In the case of a price increase or a tax: Compensating Variation (CV) Equivalent Variation (EV) Thought Experiment What is the maximum the consumer would be willing to pay to get the price increase or tax? (A negative amount!) How much would the consumer be willing to accept in lieu of the price increase or tax? (Again, a negative amount!) Normal Good Normal Good Graphs Inferior Good Inferior Good Magnitudes/ Signs If the demand for good 1 is normal: CV ± EV ± If the demand for good 1 is inferior: EV ± CV ± Note: The diagrams for inferior goods depict Giffen Goods, very inferior goods. (As prices increase, demand increases.) The same CV/EV relationships hold for inferior goods that are not Giffen....
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## This note was uploaded on 04/12/2009 for the course HKS API111 taught by Professor Avery during the Fall '08 term at Harvard.

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CV_vs_EV - ± CV ± EV If the demand for good 1 is inferior...

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