A Brief Review of Income and Substitution Effects Aaron Flaaen November 2, 2010 Consider the following example: Evan loves two things in life: hockey and reading long fiction novels. As a result, he spends all of his $200 in income each month on two goods: hockey pucks and books. Suppose the initial price of a hockey puck is $5 and the price of an E-Book online is $15. Now suppose a nationwide strike in Malaysia, a major rubber producer, causes the price of a hockey puck to rise from $5 to $10. We’re looking to characterize the price effect on the optimal consumption bundle for Evan. Total Price Effect = Substitution Effect + Income Effect Substitution Effect Measures how the change in the price of one good relative to the prices of other goods affects your consumption choices. Hint: Use relative prices: Price of one good in terms of the other good Before the price change Price of a hockey puck = 1/3 E-books Price of an E-book = 3 pucks After the price change Price of a hockey puck
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