Compensating Variation

Compensating Variation - Compensating Variation...

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Compensating Variation Compensating variation can be used to calculate the effect of a price change on an individual's overall welfare. The best way to understand it is to work through it graphically and go through a numerical example. Graphical Analysis Suppose we're interested in the effect of an increase in the price of good X on a particular person. The price goes from Px1 to Px2, where Px2 is greater than Px1. The individual has M dollars to allocate between X and Y, where Y represents all other goods and has price Py. Py and M do not have a subscripts because they will remain constant throughout the analysis. Step 1: Find the Initial Equilibrium Her budget constraint before the price increase is the following: BC1: M = Px1*X1 + Py*Y1 Given the budget constraint, she will choose bundle 1 in the diagram below and will be on indifference curve IC1. Step 2: Find the New Equilibrium Following Price Increase When the price of X rises to Px2, the budget constraint changes to the following: BC2: M = Px2*X2 + Py*Y2 The new constraint is labeled BC2 in the diagram. She now chooses bundle 2 and is clearly worse off because IC2 is lower than IC1.
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Step 3: Finding the Compensating Variation Now imagine giving her some extra money to spend after the price change. We could, in principle, give her just enough extra money for her to be able to reach her original indifference curve, IC1, at bundle 3. If we did this, she would be just as well off as she was at the beginning -- the extra
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This note was uploaded on 02/01/2011 for the course ECONOMY 6 taught by Professor Fallahi during the Spring '10 term at Cambridge.

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Compensating Variation - Compensating Variation...

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