Decomposition of the Total Effect into Substitution and Income Effects Week 4 In a demand relationship the quantity consumed changes with price but what does the quantity change actually consist of ID: 761753
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Decomposition of the Total Effect into Substitution and Income Effects Week 4
In a demand relationship the quantity consumed changes with price but what does the quantity change actually consist of? Substitution Effect - substitute other goods for A as Price of A rises Income Effect - as price of A falls, real income rises and so spend more on all goods Income and Substitution Effects Lecture 6
Direction and size of effects varies with type of good Normal Good - as price falls, consumption rises - as income rises, consumption risesInferior Good - as price falls, consumption rises - as income rises, consumption falls Giffen Good - as price falls, consumption falls - as income rises, consumption falls Application to Different Types of Goods Lecture 6
Other Goods Q A U 1 U 2 BC 2 BC 1 1 3 2 Normal Good Subs: 1 to 3 or A to C (- ve ) Income: 3 to 2 or C to B (- ve ) Price effect: A to B or 1 to 2 A B C BC 3 Decrease in Price
Other Goods Q A U 1 U 2 BC 2 BC 1 BC 3 2 3 A B C Inferior Good Subs: 1 to 3 or A to C (- ve ) Income: 3 to 2 or C to B (+ ve ) Price effect: A to B or 1 to 2 1 Decrease in Price
Other Goods Q A U 2 U 1 BC 2 BC 1 BC 3 1 3 2 A B C Giffen Good Subs: 1 to 3 or A to C (- ve ) Income: 3 to 2 or C to B (+ ve ) Price effect: A to B or 1 to 2 Decrease in Price
Income and Substitution Effects Slutsky equation Total effect of price change = SE + IESlutsky’s theorem states that the substitution effect of a price change (relative to quantity) is negative.We isolate the substitution effect by taking away from (giving) the consumer enough money to put her at the same level of satisfaction as before the price change. 7
Income and Substitution Effects Total effect of a price change for: normal good is negative . Because the negative IE reinforces the already negative SE. For price fall, quantity DD increases.Inferior good is still negative, but –SE > +IE. Quantity DD increases but less than the case for normal goods Giffen good is positive because –SE < +IE. Quantity DD falls. 8
Labor-Leisure Choice Leisure - all time spent not working.The number of hours worked per day, H , equals 24 minus the hours of leisure or nonwork, N, in a day: H = 24 − N. The price of leisure is forgone earnings. The higher your wage, the more an hour of leisure costs you.
Labor-Leisure Choice: Example Jackie spends her total income, Y, on various goods. The price of these goods is $1 per unit. Her utility, U, depends on how many goods and how much leisure she consumes: U = U(Y, N). Jackie’s earned income equal: wH. And her total income, Y, is her earned income plus her unearned income, Y*: Y = wH + Y*.
Figure 5.8 Demand for Leisure Budget Line, L 1 Y = w1H Y = w 1 (24 − N). Each extra hour of leisure she consumes costs her w 1 goods. Y , Goods per day Time constraint H 1 = 8 24 0 N 1 = 16 0 24 H, Work hours per day N , Leisure hours per day H 1 = 8 N 1 = 16 0 H, Work hours per day N, Leisure hours per day I 1 L 1 w , W age per hour (b) Demand Curve – w 1 1 Y 1 w 1 e 1 E 1 (a) Indifference Curves and Constraints
Figure 5.8 Demand for Leisure Budget Line, L 1 Y = w1H Y = w 1 (24 − N). Budget Line, L 2 Y = w 2 H Y = w 2 (24 − N ). w 2 > w1 Y , Goods per day Time const r aint H 2 = 12 H 1 = 8 24 0 N 2 = 12 N 1 = 16 0 24 H, Work hours per day N , Leisure hours per day H 2 = 12 N 2 = 12 0 H, Work hours per day N, Leisure hours per day Demand for leisure I 2 I 1 1 – w 2 L 1 L 2 w , W age per hour – w 1 1 e 2 Y 2 Y 1 w 1 w 2 e 1 E 2 (b) Demand Curve E 1 H 1 = 8 N 1 = 16 (a) Indifference Curves and Constraints
Figure 5.9 Supply Curve of Labor
Income and Substitution Effects of a Wage Change Since income effect is positive, leisure is a normal good. Y , Goods per d a y Time const r aint H 2 H * H 1 24 0 N 2 N * N 1 0 24 Substitution effect Income effect Total effect H , W o r k hours per d a y N , Leisure hours per d a y I 2 I 1 L 2 L * L 1 e 2 e 1 e *
Backward Bending Labor Supply Curve Y , Goods per d a y (a) Labor-Leisure Choice Time const r aint H 2 H 3 H 1 24 0 H , W o r k hours per d a y E 1 E 3 E 2 L 2 I 2 I 3 I 1 L 3 L 1 e 2 e 1 e 3 w , W age per hour (b) Supply Cu r v e of Labor Supply curve of labor H 2 H 3 H 1 24 0 , W o r k hours per d a y At low wages, an increase in the wage causes the worker to work more…. H but at high wages, an increase in the wage causes the worker to work less….
Ordinary curve vrs compensated demand curve Compensating variation ensures that the consumer remains on the same IC. DDc is steeper than ordinary DDo curve. The slope of the DDc curve is larger for a normal good. The Hicksian demand function.Ordinary DDo curve considers the effect of IE. The DDo is flatter . The slope of the DDo curve is smaller. The Marshallian demand function.The Marshallian demand function is the ordinary market demand function we have been discussing all along. 16
Other Goods Q A U 1 U 2 BC 2 BC 1 1 3 2 Normal Good Derive the Ordinary and Compensated Demand curves from this diagram A B C BC 3 Decrease in Price
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