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SGABCh8 - CHAPTER Wealth and Substitution Effects in Labor...

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C H A P T E R 8 Wealth and Substitution Effects in Labor and Capital Markets We introduced income and substitution effects in Chapter 7 and now extend those concepts to budgets that arise from endowments. The most important such bud- gets involve labor/leisure choices (by workers) and intertemporal consumption choices (by savers and borrowers). What we called "income effects" in Chapter 7 now be- come "wealth effects" — but the substitution effects remain exactly the same. In principle there is nothing new in this chapter — but it will become clearer why it will generally not work to simply try to memorize which way income (or wealth) effects and substitution effects point for different goods. A much better strategy is to understand the concepts and then be able to apply them to all possible circum- stances you might encounter. Chapter Highlights The main points of the chapter are: 1. When you own your current consumption bundle, a price change in either direction makes you better off (assuming low transactions costs). 2. The same is not true if your budget arises from an endowment but your op- timal choice is not the endowment bundle . If you are a net seller of a good, then an increase in the price of the good makes you better off. If you are a net buyer, an increase in the price might make you better off or worse off depending on the degree of substitutability between the goods. 3. The substitution effect looks exactly the same way regardless of whether the budget is exogenous or whether it arises from an endowment. The “wealth” effect, however, may point in a different direction. 4. Under reasonable assumptions about the underlying goods, wealth and sub- stitution effects point in different directions when choices involve labor or
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Wealth and Substitution Effects in Labor and Capital Markets 118 savings decisions. As a result labor responses to wage changes and savings responses to interest rate changes are ambiguous . This points to the impor- tance of understanding the degree of substitutability between goods as one thinks about labor and savings responses to price changes. 5. The underlying mathematics developed in part B of the chapter is exactly the same for deriving substitution effects, with the only difference emerg- ing as we derive the initial and final optimal bundles where we have to use the endowment-generated budget constraint rather than the previous exoge- nous budget constraint (in Chapter 7). 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 8, click the Chapter 8 tab on the left side of the LiveGraphs web site.
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