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An individual has preferences over housing, x (measured in square metres), and other goods, y, represented...

An individual has preferences over housing, x (measured in square metres), and other goods, y, represented by utility function u(x,y) = x4y. Her disposable income is $75000, and the price of housing is $1000/m2, while that of other goods is py = $1.

c) [10 marks] Find the compensating variation (CV) value of this policy’s effect on welfare, and provide an interpretation for it.

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Answer #1

So , as price of housing falls, so a consumer could maintain the new level of utility ( which is attained, after the 20% subsidy) , at the lower level of income, & this required reduction in income, so as to maintain new utility at original prices, is called compensating variation

So if income = CV = $ 12,261.63 , is taken from consumer, then he is as well off as at the original prices , with out subsidy

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