Income-Substitution Effects

price change effect on consumption-

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

Tuesday, October 8, 2013