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Unformatted text preview: Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY]. 1 1 Substitution Effect, Income Effect, Giffen Goods 14.01 Principles of Microeconomics, Fall 2007 Chia-Hui Chen September 19, 2007 Lecture 7 Substitution and Income Effect, Individual and Market Demand, Consumer Surplus Outline 1. Chap 4: Substitution Effect, Income Effect, Giffen Goods 2. Chap 4: From Individual Demand to Market Demand 3. Chap 4: Consumer Surplus 1 Substitution Effect, Income Effect, Giffen Goods Substitution and Income Effects The impact of price change on quantity demanded are divided into two effects: Substitution effect. Substitution effect is the change in an items consump- tion associated with a change in the items price with the utility level held constant. Income effect. Income effect is a change in an items consumption associated with a change in purchasing power with the price held constant. Figure 1 shows the two effects: L is the old budget line. P x decreases, and hence the new budget line is L . A is the optimal consumption before price change, and C is the optimal consumption after price change. L is a line that has the same slope as L and is tangent with the green indifference curve that passes through A , and B is the tangent point. The change from A to B is because of the substitution effect; The change from B to C is because of the income effect. So the total effect is point A moving to C ....
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