Let's address each case step by step, specifying whether **Compensating Variation (CV)** or **Equivalent Variation (EV)** should be used, with explanations and simple illustrative diagrams. --- ## **Key Concepts** - **Compensating Variation (CV):** The amount of money that must be given to or taken from a consumer *after* a change in prices or policy to restore their *original utility*. - **Equivalent Variation (EV):** The amount of money that would have to be given or taken from a consumer *before* a change in prices or policy to achieve the same utility change as the policy. --- ## **i) Lump-Sum Levy to Avoid Petrol Tax** **Situation:** Consumer is asked how much they would pay to avoid a future petrol tax (i.e., to keep the status quo). **Which to use?** **Equivalent Variation (EV)** **Explanation:** You want to know how much the consumer values *preventing* the tax before it happens. EV measures the maximum amount the consumer is willing to pay to avoid the change. **Diagram:** ```plaintext Income | U1 ------|-------------------- (Original utility, before tax) | |\ | \ (Indifference curves) | \ U2 ------|---\-------------- (New utility, after tax) | +----------------- Price of petrol EV: Horizontal distance between U1 at old and new petrol prices. ``` --- ## **ii) Club Membership for Discounted Swimming Lessons** **Situation:** Willingness to pay for a club membership that allows lower prices for swimming. **Which to use?** **Equivalent Variation (EV)** **Explanation:** This is a *potential* gain—how much they are willing to pay to get the new lower price (before it happens). EV measures the value of this prospective benefit. **Diagram:** ```plaintext Income | U1 ------|-------------------- (Original utility, before membership) | |\ | \ (Indifference curves) | \ U2 ------|---\-------------- (New utility, after membership) | +----------------- Price of swimming lessons EV: Horizontal distance between U1 at old and new prices. ``` --- ## **iii) Government Withdraws, Keeps Tax But Wants to Compensate** **Situation:** Tax remains, but government wants to compensate consumers to make them as well off as if the tax had been removed. **Which to use?** **Compensating Variation (CV)** **Explanation:** The government wants to know how much money to give so that, after the change (tax remains), the consumer is as well off as if the tax had been removed. CV measures the compensation required to restore *original utility* after the policy. **Diagram:** ```plaintext Income | U2 ------|----------------- (Higher utility, if tax was removed) | |\ | \ (Indifference curves) | \ U1 ------|---\----------- (Original utility, with tax kept) | +--------------- Price of whisky CV: Vertical distance to raise consumer from U1 to U2 at current prices. ``` --- ## **iv) Groceries Prices Rise, Want to Restore Pensioners’ Well-being** **Situation:** Prices rise; government wants to compensate pensioners to restore their previous utility. **Which to use?** **Compensating Variation (CV)** **Explanation:** The government is responding to a price increase that has already happened and wants to compensate pensioners so they return to their previous utility level. CV is the correct measure. **Diagram:** ```plaintext Income | U2 ------|----------------- (Original utility, before price rise) | |\ | \ (Indifference curves) | \ U1 ------|---\----------- (Lower utility, after price rise) | +--------------- Price of groceries CV: Vertical distance to raise consumer from U1 to U2 at new prices. ``` --- # **Summary Table** | Case | Use CV or EV? | Reason | |------|--------------|--------| | i | EV | Willingness to pay to avoid a future loss | | ii | EV | Willingness to pay to secure a future gain | | iii | CV | Compensation needed after a loss to restore utility | | iv | CV | Compensation to restore utility after a price rise | --- If you need more detailed diagrams (e.g., with indifference curves and budget lines), let me know!