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7. Income Efects, Substitution EfectsSlutsky

Efects o a Price Change

• When a commodity’s price decreases:

o   Substitution efect : commodity is relatively cheaper  consumer sub it for

now relatively more expensive other commoditieso   Income efect: consumers budget of $y can purchase more than before  if

income rose, consequent income eect on Q

  !hanges to Q due to "extra’ income  income efect 

#ugen luts%y  discovered changes in from $ change are always sum of pure

sub eect and income eect

Real Income Changes

• &t new prices,

o   Less income is needed to buy original bundle  real'income increased 

o   More income is needed to buy original bundle  real'income decreased 

Pure Substitution Efects

• luts%y isolated change in due to change in relative prices by as%ing:

o What is the change in when the consumers income is ad(usted so that

&t new prices, she can only buy the original  bundle)*+ic%s: - he can only (ust attain the original utility  level.

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Income Efect Total Change

Perect Comliments

• /o substitution *consume in 0xed proportions• &ll change in Q due to I!C"#E E$$ECT

Slutsky%s Efect or !ormal &oo's

• 1ost goods 2 normal *demand increases with

income.

• ub and income eect reinorce each other when a

normal goods own price changes

• ubstitution and income eects increase demand when own'price falls

o /ormal good’s ordinary demand curve slopes down

•

3aw of downward'sloping demand

 always applies to normal goods

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Slutsky%s Efects or Inerior &oo's

• ome goods 2 income'inferior *demand reduced by higher income.

• ub and income eects oppose each other when an income 4inferior goods own

price changes

5ien 5oods

• #xtreme income'inferiority

o 6ncome eect may be larger in si7e than sub eect  Q to fall as own'price

decreaseso

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• luts%y’s decomposition of the eect of price change into a pure sub and income

eecto #xplains why 3aw of *own warding'loping. emand is violated for

extremely income'inferior goods