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Chapter Eight Slutsky Equation. Effects of a Price Change u What happens when a commoditys price decreases? –Substitution effect: the commodity is relatively.

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Presentation on theme: "Chapter Eight Slutsky Equation. Effects of a Price Change u What happens when a commoditys price decreases? –Substitution effect: the commodity is relatively."— Presentation transcript:

1 Chapter Eight Slutsky Equation

2 Effects of a Price Change u What happens when a commoditys price decreases? –Substitution effect: the commodity is relatively cheaper, so consumers substitute it for now relatively more expensive other commodities.

3 Effects of a Price Change –Income effect: the consumers budget of $y can purchase more than before, as if the consumers income rose, with consequent income effects on quantities demanded.

4 Effects of a Price Change x2x2 x1x1 Original choice Consumers budget is $y.

5 Effects of a Price Change x1x1 Lower price for commodity 1 pivots the constraint outwards. Consumers budget is $y. x2x2

6 Effects of a Price Change x1x1 Lower price for commodity 1 pivots the constraint outwards. Consumers budget is $y. x2x2 Now only $y are needed to buy the original bundle at the new prices, as if the consumers income has increased by $y - $y.

7 Effects of a Price Change u Changes to quantities demanded due to this extra income are the income effect of the price change.

8 Effects of a Price Change u Slutsky discovered that changes to demand from a price change are always the sum of a pure substitution effect and an income effect.

9 Real Income Changes u Slutsky asserted that if, at the new prices, –less income is needed to buy the original bundle then real income is increased –more income is needed to buy the original bundle then real income is decreased

10 Real Income Changes x1x1 x2x2 Original budget constraint and choice

11 Real Income Changes x1x1 x2x2 Original budget constraint and choice New budget constraint

12 Real Income Changes x1x1 x2x2 Original budget constraint and choice New budget constraint; real income has risen

13 Real Income Changes x1x1 x2x2 Original budget constraint and choice

14 Real Income Changes x1x1 x2x2 Original budget constraint and choice New budget constraint

15 Real Income Changes x1x1 x2x2 Original budget constraint and choice New budget constraint; real income has fallen

16 Pure Substitution Effect u Slutsky isolated the change in demand due only to the change in relative prices by asking What is the change in demand when the consumers income is adjusted so that, at the new prices, she can only just buy the original bundle?

17 Pure Substitution Effect Only x2x2 x1x1 x 2 x 1

18 Pure Substitution Effect Only x2x2 x1x1 x 2 x 1

19 Pure Substitution Effect Only x2x2 x1x1 x 2 x 1

20 Pure Substitution Effect Only x2x2 x1x1 x 2 x 1

21 Pure Substitution Effect Only x2x2 x1x1 x 2 x 1

22 Pure Substitution Effect Only x2x2 x1x1 x 2 x 1 Lower p 1 makes good 1 relatively cheaper and causes a substitution from good 2 to good 1.

23 Pure Substitution Effect Only x2x2 x1x1 x 2 x 1 Lower p 1 makes good 1 relatively cheaper and causes a substitution from good 2 to good 1. (x 1,x 2 ) (x 1,x 2 ) is the pure substitution effect.

24 And Now The Income Effect x2x2 x1x1 x 2 x 1 (x 1,x 2 )

25 And Now The Income Effect x2x2 x1x1 x 2 x 1 (x 1,x 2 ) The income effect is (x 1,x 2 ) (x 1,x 2 ).

26 The Overall Change in Demand x2x2 x1x1 x 2 x 1 (x 1,x 2 ) The change to demand due to lower p 1 is the sum of the income and substitution effects, (x 1,x 2 ) (x 1,x 2 ).

27 Slutskys Effects for Normal Goods u Most goods are normal (i.e. demand increases with income). u The substitution and income effects reinforce each other when a normal goods own price changes.

28 Slutskys Effects for Normal Goods x2x2 x1x1 x 2 x 1 (x 1,x 2 ) Good 1 is normal because higher income increases demand

29 x2x2 x1x1 x 2 x 1 (x 1,x 2 ) Good 1 is normal because higher income increases demand, so the income and substitution effects reinforce each other. Slutskys Effects for Normal Goods

30 u Since both the substitution and income effects increase demand when own-price falls, a normal goods ordinary demand curve slopes down. u The Law of Downward-Sloping Demand therefore always applies to normal goods. Slutskys Effects for Normal Goods

31 Slutskys Effects for Income-Inferior Goods u Some goods are income-inferior (i.e. demand is reduced by higher income). u The substitution and income effects oppose each other when an income- inferior goods own price changes.

32 Slutskys Effects for Income-Inferior Goods x2x2 x1x1 x 2 x 1

33 Slutskys Effects for Income-Inferior Goods x2x2 x1x1 x 2 x 1

34 Slutskys Effects for Income-Inferior Goods x2x2 x1x1 x 2 x 1

35 Slutskys Effects for Income-Inferior Goods x2x2 x1x1 x 2 x 1

36 Slutskys Effects for Income-Inferior Goods x2x2 x1x1 x 2 x 1 The pure substitution effect is as for a normal good. But, ….

37 Slutskys Effects for Income-Inferior Goods x2x2 x1x1 x 2 x 1 (x 1,x 2 ) The pure substitution effect is as for a normal good. But, the income effect is in the opposite direction.

38 Slutskys Effects for Income-Inferior Goods x2x2 x1x1 x 2 x 1 (x 1,x 2 ) The pure substitution effect is as for a normal good. But, the income effect is in the opposite direction. Good 1 is income-inferior because an increase to income causes demand to fall.

39 Slutskys Effects for Income-Inferior Goods x2x2 x1x1 x 2 x 1 (x 1,x 2 ) The overall changes to demand are the sums of the substitution and income effects.

40 Giffen Goods u In rare cases of extreme income- inferiority, the income effect may be larger in size than the substitution effect, causing quantity demanded to fall as own-price rises. u Such goods are Giffen goods.

41 Slutskys Effects for Giffen Goods x2x2 x1x1 x 2 x 1 A decrease in p 1 causes quantity demanded of good 1 to fall.

42 Slutskys Effects for Giffen Goods x2x2 x1x1 x 2 x 1 x 2 A decrease in p 1 causes quantity demanded of good 1 to fall.

43 Slutskys Effects for Giffen Goods x2x2 x1x1 x 2 x 1 x 2 Substitution effect Income effect A decrease in p 1 causes quantity demanded of good 1 to fall.

44 Slutskys Effects for Giffen Goods u Slutskys decomposition of the effect of a price change into a pure substitution effect and an income effect thus explains why the Law of Downward-Sloping Demand is violated for extremely income- inferior goods.


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