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Unformatted text preview: the diagram, firms will now demand LDM at wmin and workers will supply LSM at wmin. We know that only the labour demanded will be employed at wmin so we have an excess supply of labour in this low wage market. The unemployment that the minimum wage policy creates is LSM LDM. Slutsky Equation Hopefully, you were exposed to the Slutsky equation in ECON 201. For those who were not, we will do a brief review of the salient points of the formulation before we construct the equation using calculus. We want to investigate how a consumer's choice of a good responds to a change in the price of the good. This response can be broken down into two effects that arise from a price change in the good, namely the substitution effect and the income effect. So, when the price of a good changes, there are two sorts of effects: The rate at which you can exchange one good for another changes, and the total purchasing power of your income is altered as a result of the price change. So let's take the example of two goods X and Y. A consumer has some preferences over X and Y represented by a utility function, U(X,Y), and a budget constraint, PXX + PYY = M. Suppose the price of X falls, PX . Then, we can see directly, that the consumer can buy more of good X with his income, M. In turn, this will affect the consumer's utility level (since we assume that MUX > 0). How do we represent this scenario? 72 Y
M / PY M / PY
B A C Shift BLO s.e i.e Pivot BLF X BLC So, in order to determine the substitution effect we need to use the consumer's demand function to calculate the optimal choices at the new price and compensated income X(PX, M) and the consumer demand at the original point X(PX, M). So the change in X due to the substitution effect is: Xs = X(PX, PY, M) - X(PX, PY, M) The change in demand for X may be large or small, depending on the shape of the consumer's indifference curves. But given the demand function, it is straight forward to plug in the numbers and calculate the substitution effect (holding PY constant). The substitution effect is often described as the change in compensated demand. The idea is that the consumer is being compensated for a price rise...
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- Spring '10