chapter 8: substitution and income effects

substitution effect - the price of a good decreases; the good is now relatively cheaper; keeps purchasing power CONSTANT

income effect - the price of a good decreases; you are now relatively more wealthy than before, and your purchasing power has increased, meaning your money buys more of that good

slutsky identity - total change in demand = substitution effect + income effect

calculating substitution effect - x1(p1’, m) - x1(p1, m)

calculating income effect - x1(p1’,m) - x1(p1’-m’)

slutsky substitution effect - aims to exactly afford the original bundle at the original prices

hicksian substitution effect - aims to adjust income so that we can exactly reach the same utility as before

if a good is normal, then the substitution effect is - substitution effect is negative

if a good is normal, then the income effect is - income effect is negative

if a good is normal, then the slope of the demand curve is - the slope is negative

if a good is inferior, then the substitution effect is - substitution effect is negative (2)

if a good is inferior, then the income effect is - income effect is positive

if a good is inferior, then the slope of the demand curve is - the slope is negative unless the inferior good is a Giffen good

if a good is a giffen good, then the substitution effect - the substitution effect is negative (3)

if a good is a giffen good, then the income effect is - the income effect is positive (2)

if a good is a giffen good, then the slope of the demand curve is - the slope is positive

reason for the positive slope of giffen good - the income effect must outweigh the substitution effect and this can only occur for inferior goods