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Unformatted text preview: Slutsky’s Equation 1 Introduction • We will be concerned with how a consumer’s choice of a good changes in response to changes in price. • Price of a good changes ⇒ there are two effects: 1. The rate at which you can exchange one good for another changes, 2. the total purchasing power of your income is altered. • Example: Good 1 becomes cheaper ⇒ you replace good 2 with good 1 + your income can buy more of both goods. • First part = substitution effect, second part = income effect. 2 The Substitution Effect • Look at the picture: 1. Price of good 1 declines 2. ⇒ Final budget line = Rotation of the original budget line around the vertical intercept (can afford more good 1). 3. Break this movement of the budget line into two pieces: Pivot around the original choice (adjust budget (-) at the new price rate to make the original choice just affordable) + increase income (shift up). • Let m be the income that makes the old bundle ( x 1 ,x 2 ) just affordable at the new price rate. • Since ( x 1 ,x 2 ) is (just) affordable at both ( p 1 ,p 2 ,m ) and ( p 1 ,p 2 ,m ) m = p 1 x 1 + p 2 x 2 m = p 1 x 1 + p 2 x 2 • Therefore...
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This note was uploaded on 11/07/2010 for the course ECO 33358 taught by Professor Mathevet during the Fall '10 term at University of Texas.
- Fall '10