Lec06-DemandFunc_IncEff_SubstEff_Theory_Evidence

Lec06-DemandFunc_IncEff_SubstEff_Theory_Evidence - Lecture...

Info iconThis preview shows pages 1–5. Sign up to view the full content.

View Full Document Right Arrow Icon
Lecture Note 6 — Demand Functions, Income E f ects and Substitution E f ects: Theory and Evidence David Autor 14.03 Applied MIcroeconomics and Public Policy, Fall 2005 1
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
1T h e e f ect of price changes on Marshallian demand A simple change in the consumer’s budget (i.e., an increase or decrease or I )invo lvesa parallel shift of the feasible consumption set inward or outward from the origin. This economics of this are simple. Since this shift preserves the price ratio ³ p x p y ´ , it typically has no e f ect on the consumer’s marginal rate of substitution (MRS), ³ U x U y ´ , unless the chosen bundle is either initially or ultimately at a corner solution. A rise in the price of one good holding constant both income and the price of other goods has economically more complex e f ects: 1. It shifts the budget set inward toward the origin for the good whose price has risen. In other words, the consumer is now e f ectively poorer. This component is the ‘income e f ect.’ 2. It changes the slope of the budget set so that the consumer faces a di f erent set of market trade-o f s. This component is the ‘price e f ect.’ Although both shifts occur simultaneously, they are conceptually distinct and have po- tentially di f erent implications for consumer behavior. 1.1 Income e f ect First, consider the “income e f ect.” What is the impact of an inward shift in the budget set in a 2-good economy ( X 1 ,X 2 ) : 1. Total consumption? [Falls] 2. Utility? [Falls] 3. Consumption of X 1 ? [Answer depends on normal, inferior] 4. Consumption of X 2 ? [Answer depends on normal, inferior] 1.2 Substitution e f ect In the same two good economy, what happens to consumption of X 1 if p 1 p 2
Background image of page 2
In other words, we want the sign of Sign ¿ ∂X 1 ∂p 1 | U = U 0 À . Provided that the axiom of diminishing MRS applies, we’ll have δX 1 δp 1 | U = U 0 < 0 . In words, holding utility constant, the substitution e f ect is always negative. By contrast, as we established above, the sign of the income e f ect is ambiguous, ∂X 1 ∂I 0 , depending on whether X 1 is a normal or inferior good. 6.1#1 This section of budget set becomes unfeasible I/ p x1 I/p x2 I/p y x y -(p x1 /p y) -(p x2 /p y) 1.3 Types of goods The fact that the substitution e f ect is always negative but the income e f ect has an ambiguous s igng ivesr isetothreetypeso fgoods : 1. Normal good: ∂X ∂I > 0 , ∂X ∂p x | U = U 0 < 0
Background image of page 3

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
6.1#2 I/p y y x S C 1 C 2 I/p x1 I/p x2 U 1 U 2 Normal good Income effect Substitution effect Although we only observe the movement from C 1 to C 2 , we can conceive of this movement as having two parts: the movement from C 1 to S (substitution e f ect) and the movement from S to C 2 (income e f ect). 2. Inferior good:
Background image of page 4
Image of page 5
This is the end of the preview. Sign up to access the rest of the document.

This note was uploaded on 04/11/2008 for the course ECON 14.03 taught by Professor Autor during the Spring '08 term at MIT.

Page1 / 21

Lec06-DemandFunc_IncEff_SubstEff_Theory_Evidence - Lecture...

This preview shows document pages 1 - 5. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online