191T3 - ECON191(Spring 2010 4 5 8.3.2010(Tutorial 3 Chapter...

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1 ECON191 (Spring 2010) 4, 5 & 8.3.2010 (Tutorial 3) Chapter 2 Consumer Theory (Chapter 3 & 4 of textbook) Income and substitution effect Substitution effect : change in consumption of a good associated with a change in its price, with the level of utility held constant. SE is always negative, i.e. when P 1 X 1 and vice versa. Income effect : change in consumption of a good resulting from an increase in purchasing power, with relative prices held constant. IE can be positive or negative Normal goods: positive IE, i.e. Y  X 1 Inferior goods: negative IE, i.e. Y  X 1 Derivation of demand curve (Uncompensated Demand) P 1 SE X 1 IE Normal good (+IE) X 1 IE + SE X 1 (Point N) Downward sloping DD Inferior good ( IE) X 1 (a) SE > IE (X 1 > X 1 ) IE + SE X 1 (Point Z) Downward sloping DD (b) SE = IE (X 1 = X 1 ) IE + SE 1 X (Point X) Vertical DD SE (IE) N Y X X 2 X 2 X 1 X 1 S X 1 2 ' 1 P P 2 1 P P IC IC X 2 X 1 N M E C B A Z (IE) Z (IE) Y (IE) X Initial equilibrium: E with P 1 , P 2 and Y Suppose P 1 to P 1 , P 2 and Y remains unchanged. New equilibrium: N with P 1 , P 2 and Y The price effect is composed of two effects: substitution effect (SE) and income effect (IE). SE IE X 2 X X 1 X 1 S X 1 2 ' 1 P P 2 1 P P IC IC X 2 X 1 N M E C B A

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2 Compensated and Uncompensated demand curve Compensated demand curve: shows the quantity demanded for a good at each price, holding utility constant. (Substitution effect only, real income remains constant)
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