review_ch8 - Chapter 8 Review: Slutsky Equation This...

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Unformatted text preview: Chapter 8 Review: Slutsky Equation This chapter looks more closely at how a consumer’s choice of a good re- sponds to a change in its price. 8.1 The substitution effect When the price of a good changes, there are two effects: the rate at which you can exchange one good for another, and the total purchasing power of your income is altered. Say, the price of good 1 falls, then you can buy more of good 1 (because it is cheaper) and the purchasing power of your money goes up (you feel richer). The first part - the change in demand due to the change in the rate of exchange between two goods - is called the substitution effect . The second effect - the change in demand due to having more (or less) purchasing power - is called the income effect . 1 2 CHAPTER 8. REVIEW: SLUTSKY EQUATION The “pivot-shift” operator gives us a convenient way to decompose change in demand into two pieces. The “pivot” locates the change in de- mand where the slope of the budget line changes (because relative prices changes) while its purchasing power remains the same. That is, with the pivot, the consumer’s purchasing power remains unchanged and the new budget line passes through the original bundle so that it is just affordable. So how much must we adjust money in order to keep the old bundle just affordable? Let m be the amount of money income that will make the old bundle just affordable; this will be the amount of income associated with the pivoted budget line. Since (the pivoted budget line....
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review_ch8 - Chapter 8 Review: Slutsky Equation This...

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