Principles of Economics- Mankiw (5th) 461

Principles of Economics- Mankiw (5th) 461 - CHAPTER 21 THE...

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CHAPTER 21 THE THEORY OF CONSUMER CHOICE 475 INCOME AND SUBSTITUTION EFFECTS The impact of a change in the price of a good on consumption can be decomposed into two effects: an income effect and a substitution effect. To see what these two effects are, consider how our consumer might respond when he learns that the price of Pepsi has fallen. He might reason in the following ways: ± “Great news! Now that Pepsi is cheaper, my income has greater purchasing power. I am, in effect, richer than I was. Because I am richer, I can buy both more Pepsi and more pizza.” (This is the income effect.) ± “Now that the price of Pepsi has fallen, I get more pints of Pepsi for every pizza that I give up. Because pizza is now relatively more expensive, I should buy less pizza and more Pepsi.” (This is the substitution effect.) Which statement do you find more compelling? In fact, both of these statements make sense. The decrease in the price of Pepsi makes the consumer better off. If Pepsi and pizza are both normal goods, the con-
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This note was uploaded on 07/30/2010 for the course ECON 120 taught by Professor Abijian during the Spring '10 term at Mesa CC.

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