Compensating variation

    Suppose you consume video rentals (V) and spend the rest of your income on other goods (Ig). A couple alternative situations are depicted in the diagram below (not drawn to scale).
    Suppose that in month a you start out with the income and video price that allows you to consume at point a in the diagram. Then in month a', you start out with the income and video price that allows you to consume at point a' in the diagram.

1. Use the information in the diagram to the right to complete the following table. A B C D E Situation Pv Qv I U a         a'            2. Suppose that your situation changed from month a to month a' because you receive an offer in month a' to pay a membership fee and join a video rental club that lets you rent videos for $1 apiece instead of $2. Based on your answers above, what is the most you would voluntarily pay as a membership fee to join a the club?     Max.fee = _______

Compensating variation (CV): The change in money income (I) which is exactly sufficient to leave utility unaffected by a price change.    3. Label where CV shows up in the top diagram.    4. In the bottom diagram, use the information in columns B and C of the table to plot a demand curve that links the points corresponding to "a" and "a'" in the top diagram.    5. Based on your demand diagram, as a result of the price change depicted in the top diagram, how large is the change in consumer surplus?       Change in consumer surplus = _______