Income and substitution effect Flashcards
What is an ordinary good?
As the price for the good falls, demand rises
What is a substitution/pure price effect?
The effect on demand due to a change in the price of good 1 and a simultaneous change in income from m
to m’
What is the income effect?
The effect on demand due to a change in income from m to m’ given the price of good 1 p1’
What is the ‘total effect’ of a price change
The difference in demand as a result of the price change in good one from p1 to p1’
What are the 2 components of the total effect of a price change?
- Substitution/pure price effect
- Income effect
What is the total effect identity?
Total effect = substitution effect + income effect
How do you solve for the Hicksian demand functions by substitution?
- Rewrite constraint for x1 and sub into objective function
- Differentiate with respect to x2
- Sub in x2 to find x1
- Check the second order condition is >0
What does the theory of duality tell us?
The solutions of UMP and EMP are equivalent as long as certain conditions hold
How do you calculate the substitution effect from a change in price?
- Calculate the income needed to keep the consumption bundle at the original level
- Use the new income and price to find the Marshallian demand functions for the goods
- Calculate the difference between the new and the original
How do you calculate the income effect from a change in price?
- Calculate the new Marshallian demand functions for the goods with just a change in price, and with a change in both income and price
- Find the difference between the two
How do you depict the income and substitution effects on a diagram?
- Calculate the resulting utilities from the two making this the indifference curve
- Intersect the respective budget constraints at the optimal bundles
