Equivalent variation

Equivalent variation (EV) is a measure of how much more money a consumer would pay before a price increase to avert the price increase. Because the meaning of "equivalent" may be unclear, it is also called extortionary variation. John Hicks (1939) is attributed with introducing the concept of compensating and equivalent variation.

It is a useful tool when the present prices are the best place to make a comparison.

The value of the equivalent variation is given in terms of the expenditure function (e(\cdot,\cdot)) as

EV = e(p_0, u_1) - e(p_0, u_0)

= e(p_0, u_1) - w

= e(p_0, u_1) - e(p_1, u_1)

where w is the wealth level, p_0 and p_1 are the old and new prices respectively, and u_0 and u_1 are the old and new utility levels respectively.

Value function form

Equivalently, in terms of the value function (v(\cdot,\cdot)),

v(p_0,w+EV) = u_1

This can be shown to be equivalent to the above by taking the expenditure function of both sides at p_0

e(p_0,v(p_0,w+EV)) = e(p_0,u_1)

w+EV = e(p_0,u_1)

EV = e(p_0,u_1) -w

One of the three identical equations above.

See also

Compensating variation (CV) is a closely related measure of welfare change.

References