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Income-Substitution Effects

price change effect on consumption - broken down into 2 parts

 

  • prices change >> income, prices both change relatively
  • substitution effect - price changes >> relative prices of good changes
    • willing to buy more of good that became relatively cheaper
    • price change for 1 good relatively effects the other good as well
    • utility stays constant, price declines >> demand increases
    • causes shift along indifference curve (to point where more of one good bought than before)
  • income effect - price falls >> relative income increases >> increase in real purchasing power
    • price held constant (as if income increased), quantity demanded depends on whether good is inferior/normal
    • outward or inward shift to new demand curve
    • inferior good >> inward shift >> may or may not overtake substitution effect
    • may be large enough to cause demand to slope upward (stop consuming some other good completely

 

  • substitution effect
  • indifference curve
  • initial budget line
  • new, relative budget line
  • though the absolute price of good 2 doesn't change, a price decrease for good 1 makes good 2 relatively more expensive >> new relative budget line

 

  • income effect
  • price decrease for good 1 leads to an overall increase in purchasing power
  • new budget line shifts outward from relative budget line found in last step
  • negative income effect >> inferior good
  • Giffen good - causes demand curve to slope upward due to very large income effect (very rare)

 

  • overall change
  • as expected, a price decrease for good 1 leads to more of good 1 and less of good 2 being bought
Subject: 
Economics [1]
Subject X2: 
Economics [1]

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