SUBSTITUTION AND INCOME EFFECT

SUBSTITUTION AND INCOME EFFECT - Econ 251 Fall 2009...

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Econ 251 Fall 2009 10/06/2009 When the relative price changes, two things happen: 1. change in the slope of the budget line ( rotation) => change in the tangency point, even if we can afford the same level of utility 2. change in the affordable consumption set ( shift in the budget line) => new consumption choice b The price effect can be decomposed into two effects: 1. Substitution Effect 2. Income Effect Def. Substitution Effect = the change in the quantity demanded of a good that results from a change in the relative price, holding the total utility constant. Def. Income effect = the change in the quantity consumed of a good that results from a change in the purchasing power. Example: Normal Goods Anna consumes coffee and bagels. Both goods are normal goods. If the price of coffee increases: The substitution effect implies that the quantity demanded of coffee decreases as it is now relatively more expensive. The increase in price also reduces Anna’s real income in terms of coffee, i.e., she
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This note was uploaded on 10/04/2011 for the course ECONOMICS 251 taught by Professor Kelly during the Spring '11 term at Purdue.

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SUBSTITUTION AND INCOME EFFECT - Econ 251 Fall 2009...

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