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Unformatted text preview: Chapter 8 Wealth and Substitution Effects in Labor and Capital Markets 1 In Chapter 7, we introduced the concepts of income and substitution effects in models where income enters the consumer’s optimization problem exogenously — i.e. where consumers are choosing to allocate a fixed money budget across consumption goods. We now turn to cases where income is endogenous — where our consumption is funded not by a fixed money budget but rather by the sale of something that we own. This can happen in consumer goods markets if we own one of the goods that is part of the analysis. More importantly, as we illustrated in some detail in Chapter 3, it happens in labor markets where we sell our leisure time and in capital markets where we buy and sell financial assets as we plan for the future. 8A Wealth Effects, Substitution Effects and Endowments In Chapter 7, we adopted the term “income effect” for the impact of parallel shifts in budget constraints on consumption behavior. Such effects occurred either because the fixed money income within the models we dealt with changed directly, or because the “real” income changed as a result of a price change. In none of the examples in the last chapter, however, did a price change ever cause something the consumer owned to change in value — the consumer, in the models of Chapter 7, in fact did not own anything but simply spent some exogenously allocated money budget. We now turn to the case where the change in the price of a good has yet a third effect because it changes the value of something we own and thus alters our budget constraint differently than it did in Chapter 7. We will call the new effect that emerges a “wealth effect” because it captures the change in wealth a consumer experiences when prices change. As we will see, the substitution effect remains exactly the same for endogenous choice sets. 8A.1 An Increase in the Price of Gasoline for George Exxon When we investigated in Chapter 7 the ways in which my consumption of gasoline might change when the price of gasoline increases, two effects emerged: the substitution effect due to the change 1 Chapters 2 through 7 are required reading for this chapter. 186 Chapter 8. Wealth and Substitution Effects in Labor and Capital Markets 2 Graph 8.1: Substitution and Wealth Effects when Income is Derived Endogenously from Selling Gasoline in the opportunity cost of gasoline, and the income effect due to the fact that my real income (as measured by the indifference curve I am able to reach) declined as a result of the price change. The situation is somewhat different for my imaginary friend George Exxon. George and I are very different in many ways — not the least of which is that he owns large reserves of gasoline. In our example below, we suppose that he finances his entire consumption by selling gasoline. Unlike my income — which we modeled as exogenous, George’s income is then more appropriately modeled as arising endogenously from the value of his gasoline “endowment”.from the value of his gasoline “endowment”....
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- Fall '07
- Hamlet, substitution effects, George Exxon