microbook_3e-page101

microbook_3e-page101 - Will you change the allocation of...

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Will you change the allocation of stocks in your portfolio? No, you won’t. You cannot earn a higher return by changing your allocation because the stocks are perfect complements. Any reallocation would leave you on a lower isoquant – your returns would fall. But what if the stocks were not perfect complements? ƇƇƇ the substitution effect – the “normal” case Rarely are two goods or two stocks are perfect complements or perfect substitutes. Normally, they’re somewhere in between. For review: x perfect substitutes – indifference curves/isoquants are straight lines x perfect complements – indifference curves/isoquants are L-shaped x somewhere in between – indifference curves/isoquants are curved (convex to the origin). For example, two stocks are not perfect substitutes when one is more risky than the other. Land and capital are not perfect complements because on a given plot of land you can build a single-family home or a 10-story apartment complex. When zoning is present however, land and capital are “near perfect complements,” but not “perfect
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