Problem 2

Supposethataconsumerinitiallyfacessomeprices(p1,1)andconsumessomebundle(x1,x2): The price of good 1 then increases from p1 to p1; while the price of good 2 remains the same at 1. Suppose that the demanded bundle at (p1, 1) is (x1;x2). Define the compensating variation (CV) and equivalent variation (EV) and explain clearly why they are called so, and then in two different diagrams depict them for the above mentioned price change. What do they really measure?

From the previous part, now suppose that the consumers utility has the form u(x1,x2) = 4x0.5+x2. Alsoletp1 =1,p1 =2andm=5. ComputetheCV andtheEV.

Based on what you obtained 2) what is the relationship between CV and EV (are they equal? are they different? or impossible to say)? Is this always the case? Explain.