Income and substitution effects handout

Income and substitution effects handout - Income and...

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Income and substitution effects handout: Suppose we have a budget, and are buying cats and hamsters only. If the price of cats increases, what are the possible effect on the optimal bundle? Substitution effect: This is the change in a consumer’s optimal bundle due to changes in relative prices. If the price of a cat increases, cats are now relatively more expensive and hamsters relatively less expensive. So the substitution effect on cats is that the consumer will want to buy less of them. The substitution effect on hamsters is that the consumer will want to buy more of them. P cat Impact on quantity of cats in optimal bundle Impact on quantity of hamsters in optimal bundle Substitution effect Income effect: This is the change in a consumer’s optimal bundle because the price change affects purchasing power. If the price of a cat increases, the consumer’s income is now effectively lower. Thus, if both goods are normal, the consumer will want to buy less of both. The overall effect is the
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This note was uploaded on 02/16/2012 for the course ECON 101 taught by Professor Gerson during the Fall '08 term at University of Michigan.

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Income and substitution effects handout - Income and...

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