L6,7,11 Flashcards
Substitution effect of a reduction in demand
Shift new budget line onto original IC. This generates BL3. Substitution effect is change from e1 to e*.
What is substitution effect
Change in demand holding other price and utility constant
What is income effect
Change in demand resulting from change in real income
Income effect of a reduction in demand
The Income effect is the change from the bundle, e* to the optimal bundle after the change in prices, e2.
Substitution effect of a price increase is always?
Negative as long as BC is linear and IC convex to origin
If a normal good and price increases income effect is?
Negative
Total effect=
Sub effect + Inc effect.
Slutsky equation
total price elasticity = substitution price elasticity - income elasticity of good x
budget share of good
According to Slutsky equation income effect for good will be negligible if?
Income elasticity close to 0
Good makes up a small fraction of consumers budget
Pros and Cons of consumer surplus
Easy to calculate using simple demand functions
However inaccurate as demand functions include income effects
3 ways of calculating welfare
Consumer Surplus
Compensating Variation - change in income consumer would need to restore his original utility
Equivalent Variation - change in income that would provide an equivalent change to consumers utility
Standard model of consumer choice assumes:
Individuals have well defined preferences
Can perfectly process all available information
Individuals are willing to select options that maximise their utility
Lefmost digit bias
consumer pays too much attention to leftmost digit of number e.g. 1.99 rather than 2.00
Decoy effect
Using an option to make another option look better
Loss averse
Individual more sensitive to a loss relative to an equivalent gain of same magnitude
