Question

Manolo spends all of his income on two goods, x & y. He always consumes the same quantity of x as he does of y, Qx = Qy. Manolo’s current weekly income is Php150 and the price of x and the price of y are both Php1` per unit. Manolo’s boss is thinking of sending him to Syria where the price of x is Php1 and the price of y is Php2. The boss offers no raise in pay, although he will pay the moving costs. Manolo says that although he doesn’t mind moving for his own sake, and Syria is just as pleasant as Iraq, where he currently lives, he is concerned about the higher price of good y in Syria: he says that having to move is as bad as a cut in weekly pay of PhpA. He also says he wouldn’t mind moving if when he moved he got a raise of PhpB per week. What are the values of A and B?

A = 50, B = 50

A = 75, B = 75

A = 75, B = 100

A = 50, B = 75

None of the above

Which is the compensating, and which the equivalent variation? Explain.

Answer 1

In Iraq:

As Manolo needs equal quantity of x and y

with each priced at Php 1 per unit

Budget constraint = 150

Thus Qx*1+Qy*1 = 150, => Qx = Qy = 75 unit

Thus total unit Manolo have is 75 unit of x and 75 unit of y

In Syria,

Price of x remain same Php 1

Price of y is Php 2

As he has same budget constraint of 150,

Manolo still need equal amount of x and y

this implies :

150 = Qx*1 + Qy*2, => Qx = Qy = 50

As increase in price of y result decrease in quantity,

This is as bad as a cut in weekly pay of PhpA which is loss of 25 quantity each ,

That is Php of 25*1+25*1 = 50

A = Php 50

This is an equivalent Variation.

He need a raise , to restore initial consumption:

that is 75*1 + 75*2 = Php225

He need raise of = 225 - 150 = Php75 = B

This is compensating Variation = Php 75