Lecture_05_Income_and_Substitution_Effects

# Lecture_05_Income_and_Substitution_Effects - Lecture 6:...

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Lecture 6: Income and Substitution E/ects c 2009 Je/rey A. Miron Outline 1. Introduction 2. The Substitution E/ect 3. The Income E/ect 4. The Sign of the Substitution E/ect 5. The Total Change in Demand 6. Examples 7. Another Substitution E/ect 8. Compensated Demand Curves 9. OPTIONAL : Calculus Derivation of the Slutsky Decomposition 1 Introduction The single most important issue in consumer theory is how demand responds to changes in the economic environment, such as changes in the prices of the goods. Common sense, and the model that we have used, suggest that an increase in p means a decrease in demand, but this is not the only possibility. Recall that, for a Gi/en good, an increase in price can mean an increase in demand. somewhat special. There are other settings, however, where these ±perverse²e/ects are plausible and natural. These include: 1) the e/ect of wage rates on labor supply 2) the e/ect of interest rates on savings 1

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In all these cases, a similar mechanism is at work. And, in all cases, a change in the relevant price can have ambiguous e/ects. Think about this intuitively for a moment: if my wage is higher, I will want to work more; but, because I feel richer, I might want to work less. Similarly, if the interest rate is higher, I will want to save more, but the higher interest rates means the return on savings is higher, so perhaps I will want to save less. A related issue, that arises even when the direction of the price e/ect is un- ambiguous, is understanding when we would expect the price e/ect to be large or small. The next section examines in more detail exactly how price should a/ect demand. 2 The Substitution E/ect The reason for the ambiguity in the e/ect of price on demand is that a price change really consists of two separate e/ects. First, a price change causes a substitution e/ect. If good 1 becomes cheaper, for example, you have to give up less of good 2 to get some of good 1. You face a di/erent rate of exchange of good 1 for good 2 in the marketplace. Second, there is an income e/ect. Because the price of good 1 is lower, you can buy more of it with a given amount of income. The purchasing power of your existing dollars has increased. Let±s look in more detail to see exactly what is going on. We will break the price movement into two steps. First, we will let relative prices change, and adjust money income to keep some- thing called purchasing power constant. 2
To see this, consider the graph below. This graph shows the e/ect of a decline in

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## This note was uploaded on 09/16/2009 for the course ECONOMICS 1010A taught by Professor Jeffreya.miron during the Fall '09 term at Harvard.

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Lecture_05_Income_and_Substitution_Effects - Lecture 6:...

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