05. Income, Subst Eff

05. Income, Subst Eff - Income and Substitution Effects;...

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Income and Substitution Effects; Labor Supply Professor John Diamond ECON 370: Microeconomic Theory Lecture 5
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2 Effects of a price decrease (or increase) Can be broken down into two components Substitution effect (SE) Commodity is relatively cheaper Substitute it for relatively more expensive commodity This substitution effect is always negative change in price and demand always opposite Income effect (IE) Price of one goods falls, w/ other constant Effectively increase in consumer’s real income Income effect on demand is positive, if normal good Two SE, IE decompositions: Hicks , Slutsky
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3 Hicks and Slutsky Decompositions Hicks SE: change in demand, holding utility constant IE: remaining change in demand, due to m/p change Slutsky SE: change in demand if real income constant IE: remaining change in demand, due to m/p change Both designed to isolate effect of change in relative prices from change in real income due to price change
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4 Hicks Substitution and Income Effects Sir John Hicks (1904-1989; Nobel Prize 1972) To get SE: Hold utility constant and find bundle that reflects new price ratio SE = change in demand due only to this change in price ratio (movement along IC) IE = remaining change in demand to get back to new budget constraint (parallel shift) Note “intermediate” budget constraint is not observed (but can be inferred)
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5 Hicks Substitution and Income Effects x 2 x 1 x 2 x 1 Initial equilibrium, before decline in p 1
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6 x 2 x 1 x 2 x 1 Hicks Substitution and Income Effects p 1 falls
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7 Hicks Substitution and Income Effects x 2 x 1 x 2 x 2 ’’ x 1 x 1 Insert “imaginary” budget line tangent to original IC and parallel to new budget line
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8 Hicks Substitution and Income Effects (x 1 ’,x 2 ’) (x 1 ’’,x 2 ’’) is pure substitution effect, reflecting substitution of x 1 for x 2 as p 1 /p 2 falls x 2 x 1 x 2 x 2 ’’ x 1 x 1
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9 Hicks Substitution and Income Effects x 2 x 1 x 2 x 1 (x 1 ’’’,x 2 ’’’) Final equilibrium on new budget set x 2 ’’ x 1
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This note was uploaded on 04/10/2010 for the course ECON 370 taught by Professor Diamond during the Spring '08 term at Rice.

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05. Income, Subst Eff - Income and Substitution Effects;...

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