Chapter 8-Slutsky Equation (Price Changes Into SE/IE)

Question 1

Income effect (IE)

Answer 1

The change in demand due to the change in purchasing power.

If the price of good 1 decreases, the purchasing power of your money has gone up although the number of dollars you have is the same, the amount that they will be able to buy has increased.

A price increase in either good decreases purchasing power.

A price decrease in either good increases purchasing power.

Question 2

Substitution effect

Answer 2

The change in demand due to the change in relative price (rate of exchange) of good 1 and 2

If for example good 1 becomes cheaper you have to give up less of good 2 in order to purchase good 1

The change in price of good 1 has changed the rate at which the market allows you to substitute good 2 for 1 (MRS)

Question 3

Inferior goods

Answer 3

Demand is reduced by higher income

In this case Substitution effect (SE) and income effect (IE) go I. Opposite directions.

*substitution effect dominates for total effect in inferior goods

Px^: SE ⬇️x and IE⬆️ TE:⬇️x
Px⬇️: SE⬆️x and IE:⬇️x TE:⬆️x

Question 4

Giffen goods (SE, IE, and TE)

Answer 4

In rare cases of extreme inferiority, the income effect may be larger in size than the SE, causing demand to fall as price falls

*income effect dominates for total effect tie breaker

Px⬆️: SE: x⬇️ IE: x⬆️ TE:⬆️
Px⬇️: SE: x⬆️ IE: x⬇️ TE: ⬇️