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compensating variation


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The amount of additional income needed to restore an individual's original level of utility following a change in the economic environment. For example, the change in the economic environment can be an increase in the price of a good, or the provision of a local park. In the first case the compensating variation will be positive and in the second case the compensating variation will be negative (assuming the consumer enjoys the good and the park). Formally, denote initial prices by p0, prices after some change by p1, and initial utility by U0. Using the expenditure function the compensating variation, CV, is given by

CV = E(p1, U0) − E(p0, U0).

See also equivalent variation.

Subjects: Economics.


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