Suppose that consumer has utility function U(X1, X2)=X½,X½. He originally face price (1,1) and has income 100. Then the price of good1 increase to 2.
a)Show steps to find compensating and equivalent variation?
Compensating Variation:
Step 1: Calculate the original utility level: U(X1, X2) = X½,X½ = 100.
Step 2: Calculate the new utility level with the new price: U(X1, X2) = X1,X½ = 200.
Step 3: Calculate the compensating variation: CV = 200 - 100 = 100.
Equivalent Variation:
Step 1: Calculate the original utility level: U(X1, X2) = X½,X½ = 100.
Step 2: Calculate the new utility level with the new price: U(X1, X2) = X1,X½ = 200.
Step 3: Calculate the equivalent variation: EV = 200 - 100 = 100.