Buying and Selling - Economics 21 Intermediate...

Economics 21: Intermediate Microeconomics Topic 2: Consumer Theory - Buying and Selling
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Economics 21: Intermediate Microeconomics
Topic 2: Consumer Theory
Buying and Selling
Reference: Varian, Chapter 9
Outline: I. Introduction
II. Slutsky Equation Revisited
I. Introduction
We have seen how the Slutsky equation can be used to decompose the effect of a price change
into an income and a substitution effect. In particular, the Slutsky Equation showed that if money
income is held constant, and the good is normal, then a reduction in its price must lead to an
increase in demand. Money income, however, does not generally remain constant. In particular, if
a consumer has an in initial endowment,
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of good 1, than a fall in the price of good 1 will lead
to a fall in the consumer’s income. In the more general case where we allow the consumer to buy
and sell, there are essentially two income effects: First, there is the ordinary income effect
measures the increase in purchasing power resulting from a price change – i.e. when a price falls,
a consumer can purchase as much of a good as he was previously and have extra money left
over.
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