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Chapter 7 - Chapter 7 Income and Substitution Effects in...

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Chapter 7 Income and Substitution Effects in Consumer Goods Markets We have just demonstrated in Chapter 6 how we can use our model of choice sets and tastes to illustrate optimal decision making by individuals like consumers or workers. 1 We now turn to the question of how such optimal decisions change when economic circumstances change. Since economic circumstances in this model are fully captured by the choice set, we could put this differently by saying that we will now ask how optimal choices change when income, endowments or prices change. As we proceed, it is important for us to keep in mind the difference between tastes and behavior . Behavior – or what we have been calling choice – emerges when tastes confront circumstances as individuals try to do the “best” they can given those circumstances. If I buy less wine because the price of wine has increased, my behavior has changed but my tastes have not. Wine still tastes the same as it did before – it just costs more. In terms of the tools we have developed, my indifference map remains exactly as it was – I simply move to a different indifference curve as my circumstances (i.e. the price of wine) change. In the process of thinking about how behavior changes with economic circumstances, we will identify two conceptually distinct causes – known as income and substitution effects. 2 At first it will seem like the distinction between these effects is abstract and quite unrelated to real world issues we care about. As you will see later, however, this could not be further from the truth. Deep questions related to the efficiency of tax policy, the effectiveness of social security and health policy and the desirability of different types of anti-poverty programs are fundamentally rooted in questions related to income and substitution effects. While we are still in the stage of building tools for economic analysis, I hope you will be patient and bear with me as we develop an understanding of these tools. Still, it may be useful to at least give an initial example to motivate the effects we will develop in this chapter – an example which will already be familiar to you if you have done end-of-chapter exercise 6.14. As you know, there is increasing concern about carbon-based emissions from auto- 1 Chapters 2 and 4 through 6 are required reading for this chapter. Chapter 3 is not necessary. 2 This distinction was fully introduces into neoclassical economics by Sir John Hicks, in his influential book Value and Capital , first published in 1939. We had previously mentioned him in part B of Chapter 5 as the economist who first derived a way to measure substitutability through “elasticities of substitution”. Hicks was awarded the Nobel Prize in Economics in 1972 (together with Ken Arrow).
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188 Chapter 7. Income and Substitution Effects in Consumer Goods Markets mobiles – and an increased desire by policy makers to find ways of reducing such emissions. Many
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