Slutsky Substitution and Income effect Flashcards
Recall definitions and progress intuition
What is the SE?
The change in demand for good 1 when the relative prices between good 1 and 2 change due to a price increase.
What is the IE?
The change in demand for good 1 due to a change in purchasing power because of a change in the price of good 1
What is the Slutsky Substitution effect?
The change in Demand for Good 1 when the relative prices between the two goods change (pivot in budget line) whilst adjusting income but keeping price of good 2 fixed.
What is the Slutsky Income Effect?
The change in Demand for good 1 when we return the adjusted income from the substitution step whilst keeping the new relative prices the same.
Normal good?
A normal good is a good for which demand increases if income increases and keeping prices constant.
Inferior good?
An inferior good is a good for which demand decreases if income increases whilst keeping prices constant.
Can a good be both a normal and inferior good?
Yes - A good can behave normally up untill a certain level of income which can act as a threshold after which the demand for the good decreases as income increases. This is also shown in an Engel curve.
What is the Total effect on demand
it is the substitution effect + the income effect
How do Inferior goods behave under SE and IE
The IE and SE act in oppoiste directions, but the SE acts opposite to the price change. If the IE outweighs the SE then the good is a Giffen Good.
How do Normal goods behave under SE and IE?
The IE reinforces the SE if the good is a normal good.
what are the SE and IE for perfect compliments?
The Sub effect is 0 because of the L shaped Indifference curve. If you pivot the the budget line around the old bundle as defined by the slutsky identity then the old bundle would still be the optimal bundle. There will be IE.
What are the SE and IE for Perfect substitutes?
huge substitution effect and a small income effect because when pivoting the new budget line around the old bundle, the optimal bundle swaps the axis it sits on.
Hick’s Substitution effect?
the change in demand for good 1 when the budget line is rolled around the indifference curve to a point where the relative prices are the same as the final budget line but a different income. in this case utility is held constant instead of purhasing power.
