Matt derives all of his utility from consuming milk shakes

Economics Dec 17, 2020

Matt derives all of his utility from consuming milk shakes. He devotes his entire $20 allowance to milk shakes each week. Suppose the price of milk shakes rise from $2 to $4. Compute Matt's Equivalent Variation (EV) of this price increase.

Expert Solution

With a $20 allowance, Matt can purchase 10 milkshakes per week when the price is $2 and only 5 per week at a price of $4.

As a result of the price increase, he would lose 5 milkshakes per week. At the original price he was already paying, those have a value to him of $10.

The equivalent variation is therefore $10 in this case.

Paying that much and avoiding the price increase would leave Matt exactly as well off at the original price as he would have been at the new price and the reduced weekly consumption of 5 milkshakes.

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