Jeremy derives all of his utility from consuming milk shakes; he devotes his entire $20 allowance to milk shakes each week. Suppose the price of milk shakes rise from $2 to $4. Compute Jeremy's Compensating Variation and Equivalent Variation
What will be an ideal response?
The CV is the amount of money needed to return Jeremy to his original level of utility. He initially consumes 20/2 = 10 shakes per week. The only way to make Jeremy as happy as before after the price rises is to give him enough income so that he can still consume 10 shakes. Thus we would need to increase his income from $20 to $40. CV = -$20.
The EV is the amount Jeremy would pay to prevent the price increase. To compute this, notice that Jeremy consumes just 20/4 = 5 shakes after the price increase. He would be willing to pay $10 of his income to prevent the price change leaving him to consume 10 shakes. Thus the EV=-$10
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