economics 111.3 winter 14 march 3 rd, 2014 lecture 18 ch. 9 ordinal utility: indifference curve...
TRANSCRIPT
Economics 111.3 Winter 14
March 3rd, 2014Lecture 18
Ch. 9 Ordinal Utility:
Indifference Curve Analysis
The Effect of Price Change• A fall in the price of a good has two
effects:1. Consumers will tend to buy more
of the good that has become cheaper and less of those goods that are now relatively more expensive
(rationale for substitution effect)2. Because one of the goods is now
cheaper, consumers enjoy an increase in real purchasing power
(real income effect as nominal income is kept unchanged)
INCOME AND SUBSTITUTION EFFECTS
• Substitution effect Change in consumption of a good associated with a change in its price, with the level of utility held constant.
• Income effect • Change in consumption
of a good resulting from an increase in purchasing power, with relative prices held constant.
The Substitution Effect of Price Change
– The substitution effect is the effect of a change in price on the quantity bought when the consumer remains on the same indifferent curve.
– When the relative price falls, the consumer always substitutes more of that good for other goods.
– The substitution effect is the first reason why the demand curve slopes downward.
The total effect of a change in price is given theoretically by the sum of the substitution effect and the income effect
Quantity of Yper week
Y*
Quantity of Xper week
X*0
Income and Substitution Effects of a Fall in Price
U1
A
Quantity of Yper week
Y*Old budget constraint
B
Substitutioneffect
New budget constraint
Quantity of Xper week
X* XB0
Income and Substitution Effects of a Fall in Price
U1
A
Quantity of Yper week
Y**Y*
Old budget constraint
B
Substitutioneffect
Incomeeffect
Total increase in X
New budget constraint
Quantity of Xper week
X* XBX**0
Income and Substitution Effects of a Fall in Price
U1
U2A
C
Substitution Effect and Income Effect
Figure Substitution and Income Effects with Normal Goods
Wine, Gallonsper year
12.0
5.5
0 58.926.7 30.6Substitutioneffect
Total effect
Income effectBeer, Gallons per year
I 2
I1
L*
L2
L1
e2
e1
e *
Income and substitution effects: sign of an effect Effect is negative, if price and quantity move in opposite directions;Effect is positive, if price and quantity move in the same direction
𝑖𝑛𝑐𝑜𝑚𝑒𝑒𝑓𝑓𝑒𝑐𝑡 :( 𝐼𝑛𝑐𝑜𝑚𝑒𝑃↓ )↑
Income and substitution effect with an inferior good: substitution effect: opposite of price movementincome effect: same direction as price movement
U1
U2
E
F
G
Good Y
Good X
Is good X inferior or normal?
Substitutioneffect Incom
eeffect
A Giffen Good