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SGABCh7 - CHAPTER Income and Substitution Effects in...

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C H A P T E R 7 Income and Substitution Effects in Consumer Goods Markest In Chapter 6 we showed how economic circumstances combine with tastes to re- sult in choice or behavior. In Chapter 7 we show how consumer choices (and thus the consumer behavior we observe) change as circumstances change — i.e. as in- comes and prices change. Put differently, we will now show how “people respond to incentives” in the consumer goods market. Chapter Highlights The main points of the chapter are: 1. There are two ways in which economic circumstances typically change : a change in income and a change in opportunity costs. 2. When only income changes , we can predict the change in behavior if we know something about how indifference curves relate to one another — be- cause we jump from one indifference curve to another. Whether tastes are quasilinear or homothetic, whether goods are normal or inferior — these are statements about that relationship between indifference curves. 3. When only opportunity costs change and real income remains constant, we don’t need to know anything about the relationship of indifference curves to one another — because the change in behavior occurs along a single indif- ference curve. Thus, the shape of the relevant indifference curve is all that matters — which is the same as saying that the degree of substitutability of the goods at the margin is all that matters. 4. Substitution effects arise as we slide along indifference curves because op- portunity costs have changed; income effects arise as we jump between in- difference curves because real income has changed.
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101 7A. Solutions to Within-Chapter-Exercises for Part A 5. Price changes give rise to both of these effects . To identify the substitution effect, we only look at the initial indifference curve and thus need to know about the substitutability of goods at the margin; to identify income effects, we have to know how indifference curves relate to one another. 6. In the calculus-based material of Part B of Microeconomics: An Intuitive Ap- proach with Calculus , we show how constrained utility maximization gives us the choices that people make as incentives change while the constrained expenditure minimization problem allows us to disentangle the substitution effect from the income effect. Using the LiveGraphs For an overview of what is contained on the LiveGraphs site for each of the chapters (from Chapter 2 through 29) and how you might utilize this resource, see pages 2-3 of Chapter 1 of this Study Guide . To access the LiveGraphs for Chapter 7, click the Chapter 7 tab on the left side of the LiveGraphs web site. In addition to the Animated Graphics , Static Graphics and Downloads portions of the LiveGraphs site, this Chapter has several Exploring Relationships modules: 1. The module titled “The Income and Substitution Effect for Two Goods” al- lows you to review all possible 2-good gases for income and substitution ef- fects.
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