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Unformatted text preview: is effect the income (or wealth) effect, since all we are doing is changing income while keeping the prices fixed at the new price vector. More precisely, the income effect, XI, is the change in the demand for good X when we change income from M to M, keeping the price of good X fixed at PX: XI = X(PX, PY, M) X(PX, PY, M) From Intermediate Micro I, we know that the wealth effect can operate in either direction. It will tend to increase or decrease the demand for good X depending on whether X is a normal or an inferior good. When the price of the good decreases (as in our example), we need to decrease income in order to keep purchasing power constant. If the good is a normal good, then this decrease in income will lead to a decrease in demand (we are moving from BLF to BLC). If the good is an inferior good, then this decrease in income will lead to an increase in demand (again, we are moving from BLF to BLC). Now, let's complete our example... Remember, that Ricky had a demand function for pepperoni given by: X = 10 + __M__ 10PP 75 The government of Nova Scotia pays Ricky $120 per week and the price of pepperoni was $3 per pound and it falls to $2 per pound...giving us Ricky's original demand for pepperoni as X(3, PY, 120) = 10 + 120/ (10 3) = 14 pounds per week. and his final demand for pepperoni at the new price of $2 as: X(2, PY, 120) = 10 + 120/ (10 2) = 16 pounds per week. So, as a result of the decrease in the price of pepperoni, Ricky now demands 2 pounds per week more of it. We calculated the amount of the 2 pound per week increase in Ricky's demand for pepperoni that was due to the substitution effect by finding his compensated demand: M = X PP = 14 (2 3) = -14 So the level of income needed to keep Ricky's purchasing power constant is: M = M + M = 120 14 = 106 So, now we have Ricky's compensated demand for pepperoni at the new price and compensated income level. X(PX, PY, M) = X(2, PY, 106) = 10 + _106__ = 15.3 (10 2) Now, we can find the magnitude of the wealth...
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This note was uploaded on 05/25/2010 for the course ECON 301 taught by Professor Sning during the Spring '10 term at University of Warsaw.
- Spring '10