INCOME AND SUBSTITUTION EFFECTS - UCLA Economics

INCOME AND SUBSTITUTION EFFECTS

[See Chapter 5 and 6]

1

Two Demand Functions

? Marshallian demand xi(p1,...,pn,m) describes how consumption varies with prices and income.

? Obtained by maximizing utility subject to the budget constraint.

? Hicksian demand hi(p1,...,pn,u) describes how consumption varies with prices and utility.

? Obtained by minimizing expenditure subject to the utility constraint.

2

CHANGES IN INCOME

3

Changes in Income

? An increase in income shifts the budget constraint out in a parallel fashion

? Since p1/p2 does not change, the optimal MRS will stay constant as the worker moves to higher levels of utility.

4

Increase in Income

? If both x1 and x2 increase as income rises, x1 and x2 are normal goods

Quantity of x2

C B A

As income rises, the individual chooses to consume more x1 and x2

U3 U1 U2

Quantity of x1

5

 ................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download