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6- wealth effects

6- wealth effects - Click to editversus Slutsky Hicksian...

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Click to edit Master title style 8/16/11 Nechyba Hicksian versus Slutsky Substitution When isolating the substitution effect , we have kept the original utility level the same at the new prices . For a price increase, this results in the green compensated budget – with compensation sufficient to keep the consumer as happy as she was originally. The resulting change in behavior is then called Hicksian substitution – or simply our usual substitution effect. A second type of substitution effect emerges when we compensate the consumer to the point of being able to afford the original bundle A at the new prices – not just the original utility level . The resulting change in behavior is called Slutsky substitution . This Slutsky Substitution effect is always in the same direction as the Hicksian effect , and the two converge to being the same for
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Click to edit Master title style 8/16/11 Nechyba I nferi or Good s Giff en Goo ds Normal Goods Quasilinear Goods The following is then a depiction of the set of ALL POSSI BLE GOODS . NECESSI TI ES Homothetic Goods LUXUR I ES Summary of All Possible Goods
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Click to edit Master title style 8/16/11 Nechyba Suppose that you owned gasoline and derived all your income from selling it. Then an increase in the price of gasoline expands your choice set . Suppose you choose bundle A prior to the price increase. The compensated budget has the same slope as the final budget but is tangent to the original indifference curve … and illustrates the substitution effect that, as always, tells the consumer to buy -- less of what has become relatively more expensive, and -- more of what has become relatively cheaper. Owning Gasoline
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Click to edit Master title style 8/16/11 Nechyba Going from the compensated to the final budget is a pure increase in income, and if consumption of gasoline does not change, gasoline is a quasilinear good. And if gasoline consumption decreases with an increase in income, then gasoline is an inferior good. If gasoline consumption increases with an increase in income, then gasoline is an normal good. The substitution and wealth effect now point in opposite directions for normal goods and the same direction for inferior goods. norm al inferi or Owning Gasoline
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Click to edit Master title style 8/16/11 Nechyba It is then easy to see why the wealth effect for the gasoline owner is different from the income effect for a gasoline consumer (who owns no gasoline).
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