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Unformatted text preview: unt of income change to "compensate" for the welfare effect of a price change so that the consumer is back to the old indifference curve. 206 EQUIVALENT VARIATIONS (EV) Unlike the compensating variation (CV) which is based on the initial point E1 to measure the welfare change from E1 to E2, EV uses E2 as the basis for comparison by asking the following question: A price change brings the consumer from E1 to E2. How much income should we take away from the consumer in order to keep them equally worse-off as after the price change? That is, we want to simulate the effect of a price change (which brings the consumer from E1 to E2) by an income change (which brings the consumer from E1 to EV) so that the consumer has the same effect as moving to the new indifference curve. Y E2 EV E1 X
Therefore, EV is the amount of income change which makes a parallel movement of the budget line from E1 (at old prices, old utility level) to EV (old prices, new utility level). In other words, EV is the amount of income change which is "equivalent" to the welfare effect of the price change so that the consumer feels the same as moving to the new indifference curve. So clearly, the main difference between CV and EV is the reference to which the welfare comparison is being made:  CV uses E1, new prices and old utility level as the basis for comparison, 207  EV uses E2, old prices and new utility level as the basis for comparison. The differences between the two measures are summarized in the following table and diagram:
Price of Good X Price of Good Y Utility Level Income E1 PX PY U M E2 PX PY U M CV PX PY U M + CV EV PX PY U M + EV A positive value for CV indicates that the consumer has been made worse off and hence, needs an increase in their income to "compensate" for the welfare loss. A negative value of CV indicates that the consumer has been made better off and hence, needs an income reduction to "compensate" for the welfare gain. On the other hand, a negative value for the EV indicates that the consumer has...
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This note was uploaded on 05/25/2010 for the course ECON 301 taught by Professor Sning during the Spring '10 term at University of Warsaw.
- Spring '10