08s - 8 2010 W. W. Norton & Company, Inc. Slutsky...

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8 Slutsky Equation
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2 Effects of a Price Change What happens when a commodity‟s price decreases? Substitution effect: the commodity is relatively cheaper, so consumers substitute it for now relatively more expensive other commodities.
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3 Effects of a Price Change Income effect: the consumer‟s budget of $y can purchase more than before, as if the consumer‟s income rose, with consequent income effects on quantities demanded.
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4 Effects of a Price Change x 2 x 1 Original choice Consumer‟s budget is $y. y p 2
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5 Effects of a Price Change x 1 Lower price for commodity 1 pivots the constraint outwards. Consumer‟s budget is $y. x 2 y p 2 y p ' 2 Now only $y‟ are needed to buy the original bundle at the new prices, as if the consumer‟s income has increased by $y - $y‟.
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6 Effects of a Price Change Changes to quantities demanded due to this „extra‟ income are the income effect of the price change.
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7 Effects of a Price Change Slutsky discovered that changes to demand from a price change are always the sum of a pure substitution effect and an income effect.
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This note was uploaded on 06/12/2011 for the course ECON 101 taught by Professor Dee during the Spring '10 term at Andhra University.

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08s - 8 2010 W. W. Norton & Company, Inc. Slutsky...

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