Lecture10. Inc&Sub2012VerE - POST

Lecture10. Inc&Sub2012VerE - POST - DEMAND Income...

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1 DEMAND Income and Substitution Effects Notes for Lecture #10
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2 Numerical Example of Income and Substitution Effects Given: U = xy, P y = 1, I = 72. Change in exogenous variable: P x decreases from P x1 = 9 to P x2 = 4. Does the fall in P x make the consumer: Feel richer? Want to buy more x instead of y? Better off? If so, by how much? What if U = 2xy instead of U = xy? Would the price decrease increase the consumer’s welfare twice as much? What if U = 10xy? y x A C U 2 =324 U 1 =144 4 9 36 72 Initial BL Slope = -9 Final BL Slope = - 4 Basket x y U(x,y)=xy A (initial) 4 36 144 C (final) 9 36 324 From Learning Objective #4 on course syllabus: You will be able to…. --- Apply the optimal choice model to generate individual and market demand curves, showing how the quantity of a good a consumer purchases depends on the prices of all goods and income. --- Explain how a change in the price of a good affects a consumer’s welfare.
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3 Income and Substitution Effects When the price of x falls from P x1 to P x2 : (i) The consumer feels richer since she can buy more of the goods, in much the same way as if her income had gone up. (An Income Effect) (ii) The consumer might thus be induced to substitute more x for some y because x is now cheaper relative to y (i.e., P x / P y has fallen). (A Substitution Effect) The analysis of income and substitution effects attempts to decompose the effect of the price change on the consumption of x into the two components, recognizing the influence of (i) and (ii). Today: Show how to find income and substitution effects. Next time: Use the information to analyze the welfare effects of price changes.
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4 Procedure to Analyze Income and Substitution Effects Graphically Step 1: Find the initial basket, A Using the initial price (P x1 ), construct the budget line BL 1 , which has slope -P x1 /P y . Denote the utility at the optimal bundle A by U 1 . Denote the quantity of x consumed at A by x A . x BL1 x A A y U 1
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5 Procedure to Analyze Income and Substitution Effects Graphically Step 1: Find the initial basket, A Using the initial price (P x1 ), construct the budget line BL 1 , which has slope -P x1 /P y . Denote the utility at the optimal bundle A by U
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Lecture10. Inc&Sub2012VerE - POST - DEMAND Income...

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