Consumer b is on their highest indifference curve at

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Unformatted text preview: orld of perfect competition. [Perfect Competition] Welfare Measures ["Real World"] Two of the most popular welfare measures are compensating variations (CV) and equivalent variations (EV). These measures are closely related to one another indeed, nearly identical, at times, in the order of magnitude. COMPENSATING VARIATIONS (CV) Consider a consumer with a utility function U = U(X,Y) and income M, and let the original prices of the goods be PX, PY. [1] At the initial consumer equilibrium (point E1), the consumer maximizes utility subject to the budget constraint according to the following conditions: MRS = PX PY PXX + PYY = M which can be solved for the quantities demanded of goods X and Y. (2) (3) (1) 204 Y E1 X [2] Suppose that PX increases to PX while everything else remains the same. The budget line rotates around the vertical intercept (inward) and the consumer revises their quantities demanded accordingly. Y E2 E1 X The new consumer equilibrium is now at point E2 where the consumer still maximizes utility but now subject to their new budget constraint according to the following conditions: MRS = PX PY PXX + PYY = M 205 (4) (5) which can be solved for the new quantities of goods demanded. The consumer has moved from point E1 to point E2 to respond to the change in prices. We want to measure the change in the consumer welfare as a result of such a move. [3] To measure the welfare change from E1 to E2, CV uses E1 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 give the consumer in order to keep him equally well off as before the price change? That is, we want to offset the effect of the price change (which brings the consumer from E1 to E2) by an income change (which brings the consumer from E2 to CV) so that the consumer gets back to the original indifference curve. Y CV E2 E1 X Therefore, CV is the amount of income change which makes a parallel movement of the budget line from E2 (at new prices, new utility level) to CV (new prices, old utility level). In other words, CV is the amo...
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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.

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