Class02_27 - Class Notes(cover part of Chapter 8 in the...

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02/27/2008 Class Notes (cover part of Chapter 8 in the textbook) Class Outline Predicting Consumer Behavior Substitution and Income Effect Predicting Consumer Behavior Def. Income effect The effect of a change in income on consumption is called income effect. Example : Peter has I=$30, and consumes Donuts and Beers, whose prices are p D = $3, p B =$3, respectively. Last week we figured out that Peter’s total utility is maximized when he consumes 5 donuts and 5 beers. Suppose Peter’s income rises to $42. We showed that in this case Peter will optimally choose to consume 7 donuts and 7 beers. Beers and Donuts are normal goods. 1
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Graphically : 2
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E’ q D 14 5 7 I 1 B 0 E 10 14 I 0 10 7 5 3 q B
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Def. Price effect The effect of a change in the price on the quantity consumed of a good is called price effect. Example : Peter has I=$30, and consumes Donuts and Beers, whose prices are p D = $3, p B =$3, respectively. Last week we figured out that Peter’s total utility is maximized when he consumes 2 donuts and 6 beers.
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