income and substitution effects (1)

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Lectures in Microeconomics-Charles W. Upton Income and Substitution Effects

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Lectures in Microeconomics-Charles W. Upton

Income and Substitution Effects

Income and Substitution Effects

Income and Substitution Effects

• We know that both price and income influence demand.

Income and Substitution Effects

Income and Substitution Effects

• We know that both price and income influence demand.

• A price change means an income change.

Income and Substitution Effects

Income and Substitution Effects

• We know that both price and income influence demand.

• A price change means an income change.

• You are purchasing 10 apples at $1 each.

• If the price falls to 50¢, you effectively get $5 more income

Income and Substitution Effects

The Basic Indifference Curve

Yo

A

I1

Utility Maximization

Yo/po

Income and Substitution Effects

The Basic Indifference CurveYo

A

I1

Utility Maximization

Yo/po

Your income is Yo; you

could purchase up

to Yo/po apples

Income and Substitution Effects

The Basic Indifference CurveYo

A

I1

Utility Maximization

Yo/po

You are on indifference

curve I1

Income and Substitution Effects

Apple Prices DropYo

A

I1

Yo/poYo/p1

Income and Substitution Effects

Apple Prices DropYo

A

I1

Yo/poYo/p1

The budget line rotates out and

you move to indifference

curve I2

I2

Income and Substitution Effects

Apple Prices DropYo

A

I1

Yo/poYo/p1

The budget line rotates out and

you move to indifference

curve I2

I2

Two things have occurred: a price

cut and an increase in

income

Income and Substitution Effects

Apple Prices DropYo

A

I1

Yo/poYo/p1

The budget line rotates out and

you move to indifference

curve I2

I2

Two things have occurred: a price

cut and an increase in

income

Lets separate those two effects starting with the

substitution effect

Income and Substitution Effects

The Substitution EffectYo

A

I1

Yo/poYo/p1

To isolate the effect of the lower price, imagine a

budget line reflecting the lower price but tangent to the old indifference curve

I2

Income and Substitution Effects

The Substitution EffectYo

A

I1

Yo/poYo/p1

To isolate the effect of the lower price, imagine a

budget line reflecting the lower price but tangent to the old indifference curve

I2

We would move to the red dot

Income and Substitution Effects

The Substitution EffectYo

A

I1

Yo/poYo/p1

To isolate the effect of the lower price, imagine a

budget line reflecting the lower price but tangent to the old indifference curve

I2

We would move to the red dotThis is the

substitution effect

Income and Substitution Effects

The Substitution EffectYo

A

I1

Yo/poYo/p1

To isolate the effect of the lower price, imagine a

budget line reflecting the lower price but tangent to the old indifference curve

I2

We would move to the red dotThis is the

substitution effect

The substitution effect is always

negative - Diminishing MRS

guarantees it

Income and Substitution Effects

The Income EffectYo

A

I1

Yo/poYo/p1

I2The

substitution effect is only

part of the story

Income and Substitution Effects

The Income EffectYo

A

I1

Yo/poYo/p1

I2The

substitution effect is only

part of the story

The other part of the impact of the price

change is the movement from the red dot to the green

dot

Income and Substitution Effects

The Income EffectYo

A

I1

Yo/poYo/p1

I2The

substitution effect is only

part of the story

The other part of the impact of the price

change is the movement from the red dot to the green

dotThis is the

income effect

Income and Substitution Effects

The Combined EffectYo

A

I1

Yo/poYo/p1

I2We effectively break the price change down

into its two components:

the substitution effect and the income effect.

Income and Substitution Effects

The Combined EffectYo

A

I1

Yo/poYo/p1

I2We effectively break the price change down

into its two components:

the substitution effect and the income effect.

While the substitution

effect is always

negative, the income

effect may or not be positive

Income and Substitution Effects

Change in Quantity Demanded for Normal and Inferior Goods

Normal Good

Inferior Good

Price ↑

Price ↓

Price ↑

Price ↓

Change in quantity demanded due to substitution effect (holding utility constant)

(-) (+) (-) (+)

Change due to income effect (holding prices constant)

(-) (+) (+) (-)

Combined Effect (-) (+) ? ?

Income and Substitution Effects

Change in Quantity Demanded for Normal and Inferior Goods

Normal Good

Inferior Good

Price ↑

Price ↓

Price ↑

Price ↓

Change in quantity demanded due to substitution effect (holding utility constant)

(-) (+) (-) (+)

Change due to income effect (holding prices constant)

(-) (+) (+) (-)

Combined Effect (-) (+) ? ?

Income and Substitution Effects

Change in Quantity Demanded for Normal and Inferior Goods

Normal Good

Inferior Good

Price ↑

Price ↓

Price ↑

Price ↓

Change in quantity demanded due to substitution effect (holding utility constant)

(-) (+) (-) (+)

Change due to income effect (holding prices constant)

(-) (+) (+) (-)

Combined Effect (-) (+) ? ?

Income and Substitution Effects

Change in Quantity Demanded for Normal and Inferior Goods

Normal Good

Inferior Good

Price ↑

Price ↓

Price ↑

Price ↓

Change in quantity demanded due to substitution effect (holding utility constant)

(-) (+) (-) (+)

Change due to income effect (holding prices constant)

(-) (+) (+) (-)

Combined Effect (-) (+) ? ?

Income and Substitution Effects

End

©2006 Charles W. Upton