Question

Indicate whether the following statements are true, false, or ambiguous. Justify your answers.

1. The price of food rises by 10 % and disposable income rises by 5 %. Someone initially spending half of his or her income on food would be neither better nor worse off as a result of these changes.

2. A person buys 2 kilograms of steak per week. The price of steak rises by $0.50 per kilogram. The compensating variation measure of the impact of this price change on this person’s welfare must be less than or equal to $1.00.

3. A person buys 2 kilograms of steak per week. The price of steak rises by $0.50 per kilogram. The equivalent variation measure of the impact of this price change on this person’s welfare must be greater than or equal to $1.00.

Answer 1

1. FALSE. Someone initially spending half of his or her income on food would now be worse off as a result of these changes because the rise in disposable income is not enough to offset the increase in price of food.

2. TRUE. Compensating variation is the additional amount a consumer needs to reach the initial utility level, not the initial bundle. In general, the CV will be smaller than the amount of money needed to buy the original consumption bundle.

3. TRUE. The EV measures the individual's maximum WTP to avoid the price increase. His income must be decreased by 1$ or an amount grater than 1$  to induce the same welfare loss as an increase in the price of steak.