Lecture 10 handout - Substitutes Complements and Slutsky Equation

Lecture 10 handout - Substitutes Complements and Slutsky Equation

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1 Substitutes and Complements Two goods are substitutes if each separately ful f lls the same desired purpose. The more substitutable are two goods, the closer to linear are the indi f erence curves. That is, the MRS does not change much as you move along the indif- ference curve. (The extreme case is perfect substitutes.) Two goods are complements if they jointly ful f ll a single desired purpose. The more complementary are two goods, the curvier the indi f erence curves; intuitively, since the two goods jointly serve the same goal, mixing them is very advantageous. That is, the MRS diminishes rapidly as you move along the indi f erence curve. (The extreme case is perfect complements.) The above de f nitions are somewhat vague because di f erent (precise) de f n- itions are useful in di f erent contexts. Here is one set of precise de f nitions that is useful in the context of consumer demand: Good 1 is a gross substitute for Good 2 if 1  2 0 . Good 1 is a gross complement for Good 2 if 1  2 0 . 2 The Slutsky Equation Suppose a consumer with income and facing prices 1 and 2 has the (optimal) consumption bundle ( 1 2 ) . Now suppose the price of Good 1 increases from 1 to 0 1 . We can see graphically that such a price increase of Good 1 can either increase or decrease quantity demanded for Good 1. Slutsky’s insight is that we can predict which will happen if we split the net e
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This note was uploaded on 04/07/2012 for the course ECON 3010 at Cornell University (Engineering School).

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Lecture 10 handout - Substitutes Complements and Slutsky Equation

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