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# lecture7 - Price Change Income and Substitution Effects THE...

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Price Change: Income and Substitution Effects

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THE IMPACT OF A PRICE CHANGE Economists often separate the impact of a price change into two components: the substitution effect; and the income effect.
THE IMPACT OF A PRICE CHANGE The substitution effect involves the substitution of good x 1 for good x 2 or vice- versa due to a change in relative prices of the two goods. The income effect results from an increase or decrease in the consumer’s real income or purchasing power as a result of the price change. The sum of these two effects is called the price effect .

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THE IMPACT OF A PRICE CHANGE The decomposition of the price effect into the income and substitution effect can be done in several ways There are two main methods: (i) The Hicksian method; and (ii) The Slutsky method
THE HICKSIAN METHOD Sir John R.Hicks (1904-1989) Awarded the Nobel Laureate in Economics (with Kenneth J. Arrrow) in 1972 for work on general equilibrium theory and welfare economics.

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THE HICKSIAN METHOD X 2 X 1 E a I 1 x a Optimal bundle is E a , on indifference curve I 1.
THE HICKSIAN METHOD X 2 X 1 I 1 x a E a A fall in the price of X 1 The budget line pivots out from P P *

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THE HICKSIAN METHOD X 2 X 1 E b I 1 I 2 x a x b E a The new optimum is E b on I 2 . The Total Price Effect is x a to x b
THE HICKSIAN METHOD To isolate the substitution effect we ask…. “what would the consumer’s optimal bundle be if s/he faced the new lower price for X 1 but experienced no change in real income?” This amounts to returning the consumer to the original indifference curve (I 1 )

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THE HICKSIAN METHOD X 2 X 1 E b I 1 I 2 x a x b E a The new optimum is E b on I 2 . The Total Price Effect is x a to x b
THE HICKSIAN METHOD X 2 X 1 I 1 I 2 x a x b E a E b Draw a line parallel to the new budget line and tangent to the old indifference curve

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THE HICKSIAN METHOD X 2 X 1 E c I 1 I 2 x a x c x b E a E b The new optimum on I 1 is at Ec. The movement from Ea to Ec (the increase in quantity demanded from Xa to Xc) is solely in response to a change in relative prices
THE HICKSIAN METHOD X 2 X 1 I 1 I 2 Substitution Effect E a E b E c This is the substitution effect.

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