e100_wntr2010_lecture6_topost

e100_wntr2010_lecture6_topost - Income & Substitution...

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• It will turn out to be very helpful to decompose effects of price changes into 2 theoretical pieces • Income and Substitution effects are hypothetical decomposition of price changes
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Can decompose PRICE changes into two components • Substitution effect: change in consumption of a good due to change in relative price, holding utility constant • Income effect: change in consumption of a good due to a change in income, holding relative prices constant
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Why is there an INCOME effect of a price change? • An increase in one (or more) prices means that fewer units of goods can be purchased. • Real income (as measured by purchasing power) has fallen
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Graph—Income and Substitution Effects (decrease price of books) CDs Books (old) (new) 1 3
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Substitution effect holds utility constant Draw budget line reflecting new price ratio, but tangent to original indifference curve 1 2
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Income effect holds prices constant • TOTAL effect – Substitution effect = Income effect • To find income effect, can draw indifference curve for TOTAL effect of price change: move from substitution effect to total is equal to the income effect
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Income effect: relative prices are held constant, only change real income 1 2 3
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1 to 2 is substitution effect: increase B, decrease CDs 2 to 3 is income effect: increase B, increase CDs 1 2 3 Books CDs
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• Total effect is sum of income + substitution effects • For decrease in price of books, predict: – increased consumption of books (I, S effects in same direction) – Unclear movement in CDs (I, S effects move in opposite directions)
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Example: Increase in P B Q A Q B old new
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Step 1: draw total effect bc & indifference curve Q A Q B old new B0 B2
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This note was uploaded on 02/27/2010 for the course ECN 40279 taught by Professor Annstevens during the Spring '10 term at UC Davis.

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e100_wntr2010_lecture6_topost - Income & Substitution...

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