Question

2.6 Marcia spends her money on coffee and sugar, which she views as perfect complements. She adds one table- spoon of sugar to each cup of coffee. A cup of cof- fee costs $1. Use graphs to show her compensating variation and equivalent variation if the price of sugar increases. Discuss the relative sizes of the change in her consumer surplus, compensating variation, and equivalent variation.

Answer 1

U(C,S) = Min[C,S]
The IC is right angled in its form and two substances are consumed in fixed proportions.

Now as prices rise from PS to PS’, the budget row rotates inward. Then we move from IC1 to IC2 to lower utility level.

CV = -EV

Compensating variation is defined as the increase of income that is necessary so that a person can keep the same level of utility at a new price set. Where an equal variation is defined as a reduction in wealth which is necessary to realize the same effect of price rises. So for that scenario.