Chapter 7

Chapter 7 - Chapter 7 Income and Substitution Effects in...

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Chapter 7 Income and Substitution Efects in Consumer Goods Markets 1 We have just demonstrated in Chapter 6 how we can use our model of choice sets and tastes to illustrate optimal decision making by economic agents. We now turn to the question of how such optimal decisions change when economic circumstances change. Since economic circumstances in this model are fully captured by the choice set, we could put this diFerently by saying that we will now ask how optimal choices change when income, endowments or prices change. At ±rst it may seem like the distinction between these eFects is abstract and quite unrelated to real world issues we care about. As you will see later, however, this could not be further from the truth. Deep questions related to the e²ciency of tax policy, the eFectiveness of social security and health policy and the desirability of diFerent types of anti-poverty programs are fundamentally rooted in questions related to income and substitution eFects. While we are still in the stage of building tools for economic analysis, I hope you will be patient and bear with me as we develop an understanding of these tools. 7A Graphical Exposition oF Income and Substitution Efects There are two primary ways in which choice sets (and thus our economic circumstances) can change: ³irst, a change in our income or wealth might shift our budget constraints without changing their slopes — and thus without changing the opportunity costs of the various goods we consume. Second, individual prices in the economy — whether in the form of prices of goods, wages or interest rates — may change and thus alter the slopes of our budget constraints and the opportunity costs we face. These two types of changes in choice sets result in diFerent types of eFects on behavior, and we will discuss them separately in what follows. ³irst, we will look only at what happens to economic choices when income or wealth changes without a change in opportunity costs (Section 7A.1). Next, we will investigate how decisions are impacted when only opportunity costs change without a change in real wealth (Section 7A.2). ³inally, we will turn to an analysis of what happens when changes in income and opportunity costs occur at the same time — which, as it turns out, is typically the case when relative prices in the economy change. 1 Chapters 2 and 4 through 6 are required reading for this chapter. Chapter 3 is not necessary.
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158 Chapter 7. Income and Substitution Efects in Consumer Goods Markets 2 7A.1 The Impact of Changing Income on Behavior What happens to our consumption when our income increases because of a pay raise at work or when our wealth endowment increases because of an unexpected inheritance or when our leisure endowment rises due to the invention of some time saving technology? Would we consume more shirts, pants, Coke, housing and jewelry? Would we consume more of some goods and fewer of others, work more or less, save more or less? Would our consumption of all goods go up by the same proportion as our income or wealth?
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This note was uploaded on 04/07/2008 for the course ECON 55 taught by Professor Rothstein during the Fall '07 term at Duke.

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Chapter 7 - Chapter 7 Income and Substitution Effects in...

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