Term 1 Week 5: Income and Substitution effects and Optimising Graphically Flashcards
(8 cards)
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 (2)
-In the Hicksian method, you keep utility constant through shifting the new BC inwards onto the old indifference curve
-In the Slutsky method, you keep purchasing power constant, through making the original bundle just attainable on the new budget constraint
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
