SUBSTITUTION AND INCOME EFFECT

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

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Econ 251 Fall 2009 10/06/2009 SUBSTITUTIOglyph817 Aglyph817D Iglyph817COME EFFECT 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 barb4right 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.
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