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Compensating Variation, Equivalent Variation, Consumer Surplus, Revealed Preference

Compensating Variation, Equivalent Variation, Consumer Surplus, Revealed Preference

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Published by hishamsauk

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Published by: hishamsauk on Mar 21, 2011
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06/03/2013

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M
ICROECONOMICS
: C
OMPENSATING
ARIATION
, E
QUIVALENT
ARIATION
, C
ONSUMER
S
URPLUS
,R
EVEALED
P
REFERENCE
 
T
HE
P
ROBLEM
If there is a shift in demand for any reason (a tax,health scare, change in preferences etc.) we want tobe able to judge whether the consumer is better orworse off.
One possible way is to simply plug the new quantitiesof the chosen goods back into the utility function:
y
Problem is that UTILITY IS ORDINAL MEASURE:
One
can·t
 
compare
u
tility
 
levels
between individuals.
The extent of the
d
ifference
b
etween
u
tility
 
levels
 
is
 
meaningless
.
W
e want a measurable, comparable, monetary valueof the change in welfare ² this can be given in threeforms:
y
COMPENSATING VARIATION
IN INCOME
y
EQUIVALENT VARIATION
IN INCOME 
 
C
OMPENSATING
V
ARIATION
Consider a consumer with anexpenditure function of E(Px,...,U1).
W
hen there is an increase of Pxto Px·,
the
 
amo
u
nt
 
of 
 
income
 
compensation
 
req
u
ire
d
 
to
 k
eep
 
the
 
cons
u
mer
 
on
 
the
 
original
u
tility
 
u
nction
U1
will be:
CV = E(Px
·
,...,U1) ²E(Px,...,U1)
This is shown on the diagramto the right, where
re
d
 
is
 
the
 
initial
 
sit
u
ation
 
an
d
b
l
u
e
 
is
 
after
 
the
 
price
 
change
.
However, due to problemsobserving people·s utilityfunctions, we can rarelyobserve the CV via this method² Instead one has to use aCompensated Demand Curve(shown on a later slide).
E(Px·,...,U1)E(Px,...,U1)
CV 
U1
E(Px,...,U1)E(Px
·
,...,U1)
X

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