Principles of Economics- Mankiw (5th) 462

Principles of Economics- Mankiw (5th) 462 - expensive so...

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476 PART SEVEN ADVANCED TOPIC income and substitution effects work in opposite directions. This conclusion is summarized in Table 21-2. We can interpret the income and substitution effects using indifference curves. The income effect is the change in consumption that results from the movement to a higher indifference curve. The substitution effect is the change in consumption that results from being at a point on an indifference curve with a different marginal rate of substitution. Figure 21-10 shows graphically how to decompose the change in the con- sumer’s decision into the income effect and the substitution effect. When the price Table 21-2 G OOD I NCOME E FFECT S UBSTITUTION E FFECT T OTAL E FFECT Pepsi Consumer is richer, Pepsi is relatively cheaper, so Income and substitution effects act in so he buys more Pepsi. consumer buys more Pepsi. same direction, so consumer buys more Pepsi. Pizza Consumer is richer, Pizza is relatively more Income and substitution effects act in so he buys more pizza.
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Unformatted text preview: expensive, so consumer opposite directions, so the total effect buys less pizza. on pizza consumption is ambiguous. I NCOME AND S UBSTITUTION E FFECTS W HEN THE P RICE OF P EPSI F ALLS Quantity of Pizza Quantity of Pepsi Income effect Substitution effect B A C New optimum I 1 2 Initial optimum New budget constraint Initial budget constraint Substitution effect Income effect Figure 21-10 I NCOME AND S UBSTITUTION E FFECTS . The effect of a change in price can be broken down into an income effect and a substitu-tion effect. The substitution effect—the movement along an indifference curve to a point with a different marginal rate of substitution—is shown here as the change from point A to point B along indifference curve I 1 . The income effect—the shift to a higher indifference curve—is shown here as the change from point B on indifference curve I 1 to point C on indifference curve I 2 ....
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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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