income subst effects - Q donuts Q hot chocolate 3 1 Price...

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Income and Substitution Effects
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Q donuts Q hot chocolate 1 3 Price of donuts decreases , so the budget line rotates outward. The consumer equilibrium moves from point 1 to point 3. Lower prices increase the consumer’s utility. IC2 IC1
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1 to 2: substitution effect (lower relative price of donuts encourages an increase in donut consumption and a decrease in hot chocolate) 2 to 3: income effect (higher purchasing power encourages an increase in donut consumption, implying donuts are normal goods) 1 3 2 Q of donuts Q of hot chocolate The substitution effect focuses just on the change in the slope of the budget line from the change in relative prices (the green dotted line has the same slope as the new budget line, but it’s tangent to the original indifference curve). The income effect focuses just on the increase in purchasing power from lower prices (shift from the green dotted line to the red line).
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Unformatted text preview: Q donuts Q hot chocolate 3 1 Price of donuts increases , so the budget line rotates inward. The consumer equilibrium moves from point 1 to point 3. Higher prices reduce the consumers utility. IC1 IC2 The substitution effect focuses just on the change in the slope of the budget line from the change in relative prices (the green dotted line). The income effect focuses just on the decrease in purchasing power from higher prices that encourages the consumer to purchase less of a normal good (shift from the green dotted line to the blue line). Q donuts Q hot chocolate 3 1 IC1 IC2 2 1 to 2: substitution effect (higher relative price of donuts encourages a decrease in donut consumption and an increase in hot chocolate) 2 to 3: income effect (lower purchasing power encourages a decrease in donut consumption, implying donuts are normal goods)...
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This note was uploaded on 04/07/2008 for the course ECON 251 taught by Professor Blanchard during the Spring '08 term at Purdue University-West Lafayette.

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income subst effects - Q donuts Q hot chocolate 3 1 Price...

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