Background
Equivalent variation (EV) is an important concept in microeconomics, particularly in consumer theory and welfare economics. It measures the monetary equivalent of a change in the economic environment, such as a price change or policy implementation, by indicating how much additional income a consumer would need to reach the same utility level as they would with the environmental change.
Historical Context
The concept has roots in the work of John Hicks (1939). Hicks’s foundation on compensated demand is fundamental to defining consumer surplus changes. Equivalent variation builds upon these ideas, providing another method of measuring welfare changes.
Definitions and Concepts
Equivalent variation refers to the amount of additional income required to achieve the level of utility an individual would attain if the economic circumstances change. This is illustrated in an economic scenario where the price of a good decreases; the consumer is better off. The derived equivalent variation quantifies the required income increment to equate utility levels without the price drop.
Mathematically, it can be denoted using the expenditure function, E(p,U), as: \[ EV = E(p’, U^) - E(p, U^) \] where:
- \( E(p,U) \) is the minimum expenditure required to achieve utility level \( U \) given price vector \( p \),
- \( p’ \) is the new price vector,
- \( U^* \) is the initial utility level.
Major Analytical Frameworks
Classical Economics
In classical economics, it would be linked to how individuals allocate resources to maximize utility in the face of price changes.
Neoclassical Economics
Neoclassical economics focuses on the allocation of resources. Equivalent variation aligns with neoclassical consumer theory’s framework, emphasizing utility maximization and expenditure minimization.
Keynesian Economics
Though Keynesian economics centers on macroeconomic aggregate demand, household consumption can still relate to equivalent variation in assessing welfare impacts of fiscal policies.
Marxian Economics
Marxian economics primarily deals with production and class struggle. While not directly linked, welfare measures like equivalent variation could theoretically apply to analyze consumer well-being under different production modes.
Institutional Economics
Analyzing the role of institutions and their impact on resource allocation, equivalent variation may address how institutional changes influence consumer utilities.
Behavioral Economics
Behavioral economics, emphasizing psychological factors and biases in decision-making, can use equivalent variation to evaluate how perceptions of welfare change with varying economic conditions.
Post-Keynesian Economics
Post-Keynesian approaches against equilibrium focused models might find equivalent variation useful in understanding real-world implications of changes in prices and income, diverging from purely theoretical constructs.
Austrian Economics
Given the Austrian emphasis on individual preference and subjectivity, equivalent variation fits well as it considers individual utility in the face of economic changes.
Development Economics
Here, equivalent variation is a practical tool in measuring how policy changes impact welfare, particularly in developing economies where price changes can significantly alter consumer well-being.
Monetarism
In monetarism, while the focus is on the money supply, equivalent variation could be used indirectly to study welfare effects of changes due to inflation or deflation.
Comparative Analysis
Equivalent variation, versus compensation variation (CV), compares constructs used in consumer welfare changes. While both measure welfare economics, EV assumes staying on initial utility after changes, whereas CV keeps utility at new equilibrium.
Case Studies
Potential case studies could include:
- Release of government subsidy impacts.
- Welfare implications of tax reforms.
- Influence of significant price reductions due to policy changes on consumer utility.
Suggested Books for Further Studies
- “Microeconomic Theory” by Andreu Mas-Colell, Michael D. Whinston, and Jerry R. Green.
- “Consumer Theory” by Hal R. Varian.
- “The Welfare Economics of Markets” by Allan M. Feldman and Roberto Serrano.
Related Terms with Definitions
- Compensating Variation (CV): The amount of income required to restore an individual’s original utility following a change in the economic environment.
- Utility: A measure of satisfaction or pleasure that individuals receive from consumption of goods and services.
- Expenditure Function: A function representing the minimum expenditure needed to achieve a given utility level at particular prices.
