Economics 2150A/B Lecture Notes - Indifference Curve, International Polar Year, Final Good

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Published on 15 Nov 2012
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Chapter 5
Changes in Income: one effect
Income Effect(IE): Change in the demand for a good resulting from a change in income
- A shift in the budget line
Normal Good: Income Effect is positive (goes up)
Inferno Good: Income Effect is negative (goes down)
-Shift in the budget line does not affect optimality condition ie the ray
Change in Price: two effects
Income Effect Income unchanged but purchasing power changes, so it’s as if income changed.
Substitution Effect A change in price affects optimality condition ie affects relative amounts of x and y
consumed
Specifically Substitution Effect The change in consumption of x and y caused by a change in relative
prices, Px/Py, which keeps the consumer indifferent.
Ie. Same indifference curve, and same level of utility
Example
U = xy, Px increases from Px1 to Px2, Py is constant
Overall effect of Px increasing is moving to a steeper budget line
Substitution Effect is the move up the indifference curve to a price they cant afford
Income Effect is the movement from the previous point to the steeper indifference curve point.
Decomposition Bundle Bundle where consumers are as well off as point A, but they face the new
prices. (old utility curve, new prices)
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Decomposing Income and Substitution Effect
Step 1
Solve for initial bundle
Step 2
Solve for final bundle
Step 3
Solve for decomposition bundle
5-4
Step 1 Initial Bundle
X = (1/1+1)72/9 Y = (1/1+1)72/1
X = 36/9 Y = 36
X = 4 (4,36)
Step 2 Final Bundle
X = (1/1+1)72/4 Y = (1/1+1)72/1
X = 36/4 Y = 36
X = 9 (9,36)
Step 3 Decomposition Bundle
U(B) = U(A)
XbYb = 4x36 (old utility)
MRS = y/x = Px2/Py = 4 (new prices)
y/x = 4
y = 4x
Sub in y = 4x
X(4x) = 4 x 36
X2 = 36
X = 6, y = 24. Sub in Y to make it equal 4 x 36
Bundle is (6,24)
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