Term 1 Week 5: Income and Substitution effects and Optimising Graphically Flashcards
How can we cancel the income effect on the budget constraint (2)
-Graphically, when price falls, the budget constraint pivots, but this means real income rises
-If we ignore the change in real income, we create a new compensated budget constraint and shift it inwards
What is the difference between the Hicksian and Slutsky methods of solely considering the substitution effect (3)
-In the Hicksian method, you keep utility constant through shifting the BC inwards onto the new indifference curve
-In the Slutsky method, you keep purchasing power constant, through making the original bundle just attainable on the new budget constraint
-Either way only considers the substitution effect
How to graphically illustrate the Hicksian method of isolating the substitution effect with a decrease in price for a normal good (5,2)
-On a budget constraint diagram with goods x and y, draw your IC, find the optimal point and label this A and x1
-If the price of good x falls, the budget constraint pivots outwards around the Y axis
-Draw a new indifference curve on this budget constraint, label this point C and x3
-Create a compensated budget constraint by shifting the budget constraint inwards so that it is at a tangent to the original IC
-Find the the new optimum point on the original IC curve, label this B and x2
-x1 -> x2 = substitution effect
-x2 -> x3 = income effect
How might the Hicksian diagrams change depending on the type of good (3, 1)
-For a normal good, both the substitution and income effect will be positive
-For an inferior good, the substitution effect will be positive, income effect negative, and sub > income
-For a giffen good, the substitution effect will be positive, income effect negative, and sub < income
-This shows how the substitution effect will always remain positive, but the income effect can impact what direction/magnitude consumption moves in response to a change in price
How to graphically illustrate the Slutsky method of isolating the substitution effect with a decrease in price for a normal good (5,2)
-On a budget constraint diagram with goods x and y, draw your IC, find the optimal point and label this A and x1
-If the price of good x falls, the budget constraint pivots outwards around the Y axis
-Draw a new indifference curve on this budget constraint, label this point C and x3
-Create a compensated budget constraint by shifting the budget constraint inwards so that it crosses through your original consumption point
-Draw a new indifference curve for this compensated BC, find the tangency point there, and label this B and x2
-x1 -> x2 = substitution effect
-x2 -> x3 = income effect
What is the Primal and the Dual, and how does the Hicksian process use them (2,1)
-The Primal is utility maximisation (what’s the highest IC subject to the target BC)
-The Dual is expenditure minimisation (whats the lowest BC subject to the target IC)
-With the Hicksian, you use the primal approach for points A and C, then dual for point B
What are the three different types of demand curve (3,1)
-Marshallian demand curve, accounts for substitution and income effect
-Hicksian demand curve, considers substitution, keeps utility constant
-Slutsky demand curve, considers substitution, keeps purchasing power constant
-Since H and S only consider the substitution effect, the type of good makes no difference, whereas Marshall slopes upwards for giffen
How to graphically derive the demand curves (4)
-Have 2 graphs vertically on eachother, the top being good X and Y, the bottom being Good X and Price X
-Assume the price of good X falls, shifting the BC outwards, the new point is where you derive MD from
-Then optimise with the hicksian/slutsky method, that creating the 2 points on the bottom diagram to make those demand curves
-All the curves will share the starting point, then the second point will be highest for M, then S, then H
