Compensating Variation and Equivalent Variation

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Compensating Variation and Equivalent Variation

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Compensating variation and equivalent variation are monetary measures of the gain or loss in a consumer's welfare following an economic change.

Compensating Variation (CV) is the compensating payment that leaves the consumer as well off as before the economic change. The compensating payment is positive for a welfare loss and negative for a welfare gain. Think about the payment as being to the consumer in the case of a welfare loss and from the consumer in the case of a welfare gain.

Let the economic change be an increase in the price of good x for the consumer choice problem discussed in class. In the figure shown below, a price increase moves the consumer from consumption bundle A to consumption bundle B.

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To be as well off as before the price increase, the consumer must receive a compensating payment that allows the consumer to move to the initial utility level at the new price of x. The budget constraint associated with the compensating payment is shown in red below. Think about the CV as the minimum amount that the consumer will accept as compensation for the welfare loss associated with the price increase.

The CV for the price increase is easily calculated using Goal Seek. Let's go back and look at a portion of your results for the previous ...

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