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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,
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