consumer theory 3

consumer theory 3 - Income-substitution decomposition Law...

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1 Income-substitution decomposition • Law of Demand: for most goods, when the price increases, the quantity demanded decreases. • There are two effects at work. – When the price of good 1 increases, it effectively decreases the consumer’s purchasing power. This is the income effect. – Also, as the price of good 1 increases, it becomes less attractive to the consumer relative to good 2. This is the substitution effect. • We can actually show the two effects using our budget line / indifference curve set up… The substitution effect: the component of the total effect of a price change that results from the associated change in the relative attractiveness of other goods. – Always causes quantity purchased to move in the opposite direction from the change in price The income effect: the component of the total effect of a price change that result from the associated change in real purchasing power. – Direction of income effect depends on whether good is normal or inferior • for normal goods, works in the same direction as substitution effect • for inferior goods, works in the opposite direction as substitution effect q1* q1* q1 q2 To complete the decomposition: Draw a line tangent to the new indifference curve, parallel to the old budget line. Income-substitution decomposition: normal good, increase in price A C B Total Effect Income-substitution decomposition: normal good, increase in price q1 q2 IE: income effect - parallel shift. SE: substitution effect - swivel. I.E. S.E. For normal goods, the IE and the SE move in the same direction. A C B q1* q1* Predicting Consumer Behavior – Initially, Lisa has an income of $30, the price of a movie is $6, and she consumes at point C . Lisa’s best affordable point is then J . The move from point
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This note was uploaded on 04/13/2008 for the course ECON 1 taught by Professor Tang during the Spring '08 term at UCSD.

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consumer theory 3 - Income-substitution decomposition Law...

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