The compensation variation and equivalent variation will be close to each other when

a. the income elasticity of demand is very large

b. the budget share is very large

c. the price change is large

d. the product of the budget share and the income elasticity of demand is small.

Solutions

Expert Solution

We have two-component in the question i.e. 1.Compensation Variation and 2.Equivalent variation

From the indifference curve analysis, we have studied Price consumption curve and in which we saw when the price of the good falls, other thing remaining the same consumer would move to new equilibrium position at higher indifference curve. This movement is only due to the price effect

As per the Hicksian approach, there are two methods splitting the price effect into income effect and substitution effect

1.Compensation variation-To offset the gain in satisfaction resulting from a fall in the price of the good we must take away from the consumer enough income to force him to come back to the original indifference curve. This required reduction in income (Say through levying a limp sum tax) to cancel out the gain in satisfaction by a reduction in the price of a good is called compensating variation

2.Equivalent variation-Now the same increase in satisfaction can be achieved through bringing about an increase in his income, price remaining constant.this is called equivalent variation because it represents variation income that is equivalent in terms of gain in satisfaction to a reduction in the price of the good.

The correct answer is (C) the price change is large- As it's related to change in the price of the good

(a) income elasticity of demand is large when income spent on good rises as income increase

(b)the budget share-its not related

(d) the product of the budget share and the income elasticity of demand is small.- it's not relevant

Rahul Sunny answered 2 years ago

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