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Lecture 14

ECON366 Lecture 14: Uncompensated Costs

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Dana Andersen

ECON 366 Lecture Substitution and Income effects Compensated Price Change Formula Chart A (PxPy) 0 (PxPy)1 Assume (PxPy) 0 < (PxPy)1 The change in consumption bundle corresponding compensated is known as the substitution effect (Hicks substitution) Why called a compensated price change? If x goes up, y remains constant, then we give or take their income in order to remain the same indifference curve Suppose P beef goes up, what is the welfare effect of this? The welfare effect is same thing of amount that we have to give to the individual to remain the same indifference curve. What is substitution effect? The marginal rate of substitution is decreasing as increasing X, if the x relative to y is increasing, then we look for the compensated change, so we try to decrease x consumption and increase y Income changes Formula Chart B Suppose I o 1 , andoI < 1 I = P X + P Y, o x y Bo: y = IoPy PxPyX B1: y = I1Py PxPyX The change of income directly cause the change of consumption, A: combination of X and Y B: combination of X and Y after the change of income (goes up) X is a normal good, when income goes up, then X consumption increases X is an inferior good, when income goes up, then X consumption decreases Ex. burning wood for heating, as individual has higher level income they probably burn less wood for heating, such as gas The change in consumption decisions due to change in income is called income effect Uncompensated Price Change It consists of two effects:
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