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When the price of one goods falls, w/ other constant; Effectively like increase in consumers real income Since it unambiguously expands the budget set Income effect on demand is positive, if normal good
Substitution effect
Measures the effect of the change in the price ratio; Holding some measure of income or well being constant Consumers substitute it for other now relatively more expensive commodities That is, Substitution effect is always negative
Slutsky
Substitution Effect: change in demand, holding real income constant Income Effect: Remaining change in demand, due to m change
x2
x2
x1
x1
x1
Substitution Effect Income Effect
x1
x2
and find bundle that reflects new price ratio Substitution Effect = change in demand due only to this change in price ratio (movement along IC) Income Effect = remaining change in demand to get back to new budget constraint (parallel shift)
x1
x1
x2
For Normal goods, the income effect reinforces the substitution effect For Inferior goods, the two effects offset For Giffen Goods
Remember, the Income effect is Negative And the income effect is greater than the substitution effect
x1
Substitution Effect Income Effect
Econ 370 - Ordinal Utility
x1
10
x2
x2
x1
Substitution Effect Income Effect
Econ 370 - Ordinal Utility
x1
x1
Substitution Effect Income Effect
11 Econ 370 - Ordinal Utility
x1
12
x2
x1
Initial demands: xi0 = xi( p10, p2, m) Final demands: xi1 = xi( p11, p2, m)
13 Econ 370 - Ordinal Utility 14
Hicks Mathematics
The only difference is between Hicks and Slutsky is in the calculation of the intermediate demand Let mh the income that provides exactly the same utility as before at the new price
If u0 is initial utility level, then Thus: mh solves u0 = u( x1(p11, p2, mh), x2(p11, p2, mh))
Finally we have:
Substitution Effect: Income Effect:
Econ 370 - Ordinal Utility
Finally we have:
SE = xis xi0 IE = xi1 xis
15
We get: ms m p1 x + (1 ) = 2 m + (1 ) m x s = 1 = 1 0 0 px px px px p1 x or x s = x 0 + (1 )x1
Finally, we get:
m =
0 p1 xx
p1 x
p1 m m x ( ) + 1 p = y 0 + (1 ) m 0 p px y px
17
SE = x s x 0 = x 0 + (1 )x1 x 0 = (1 ) x1 x 0 IE = x1 x s = x1 x 0 + (1 )x1 = x1 x 0
Econ 370 - Ordinal Utility
] (
)
18
= px
1 p y
mh = p0 x
1 p y
m
1
mh m p1 m x = = 1 1 0 0 1 px px p x px px
( ) ( )1
1 p y
Finally, we get:
p1 x SE = x x = x 0 x0 px
s 0
19 Econ 370 - Ordinal Utility
or
p1 x mh = p0 m x
p1 x IE = x x = x x 0 px
1 s 1
20
Demand Curves
We have already met the Marshallian demand curve
It was demand as price varies, holding all else constant
There are two other demand curves that are sometimes used Slutsky Demand
Change in demand holding purchasing power constant The function xis = xi( p11, p2, ms) we just defined
Hicks Demand
Change in demand holding utility constant The function xih = xi( p11, p2, mh) we just defined
Econ 370 - Ordinal Utility 21 Econ 370 - Ordinal Utility 22