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OSU ECON 4001.01 - Income Effect

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Econ 4001 1st Edition Lecture 6Outline of Last Lecture II. Companies Production Based on Consumer PreferencesIII. Revealed PreferenceIV. Marginal Utility and the Equalization PrincipleV. Condition for Equal Marginal Principle to HoldVI. Rationing Outline of Current Lecture VII. Demand Curve for an Individuala. DefinitionVIII. Consumer Choice with changing priceIX. Aspects of the Price-Consumption Curvea. Defining the curveX. Consumer Choice with Changing IncomeXI. Income Consumption CurveXII. Engel CurvesXIII. Substitutes and ComplimentsXIV. Income and Substitution EffectsXV. Substitution Effects of a Price Increasea. Price Increase ExampleCurrent Lecture- Demand curve for an individual: Definitiono Demand curve traces out quantity demanded for a good as price of that good changes- Consumer Choice with changing priceo Budget is $20o Food starts out at $1: Indifference curve U2 is highest utility so consumer chooses basket Bo If food drops to 50 cents per unit, higher utility is possible, basket D is affordable and utility is U3These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.o If food price raises, the utility is reduced to U1 and basket A is chosen- Aspects of the price-consumption curveso Price-consumption curve- traces out the satisfaction(utility) maximizing combination of two goods chosen as the price of one changes- Consumer Choice with Changing incomeo As income increases, higher utility can be achievedo However, we’re not moving along the demand curve, but rather the demand curve shifts inward/outward depending on the change of income- Income Consumption Curveo Expansion path of consumption depends on the income elasticity of each of the goodso Path shown is for two normal goods-higher levels of income result in increase of demand for these goodso Opposite for inferior goods- example hamburgers vs. steak as income goes down,increases demand for hamburgers (because they are cheaper) and the opposite occurs for steak - Engel Curveso Graphical relationship of consumption to incomeo With a normal good, quantity demanded and consumption increase as income rises- Substitutes and complimentso Substitutes: increase in the price of A causes an increase in the quantity demanded of B Cross elasticity is positiveo Complements: increase in the price of A causes a decrease in the quantity demanded of good B Cross price elasticity is negativeo Independent: increase in price of A has no effect on the quantity demanded of good B Cross price elasticity is 0- Income and Substitution effectso As the price of a good falls, there are two impacts on the consumer 1) consumer will buy relatively more of the cheaper good and less of the other goods (substitution effect) 2) consumer is able to buy more of all goods because budget line has moved out (Income effect)o Substitution effect: change in consumption of a good due to its change in price with utility held constant o Income effect: change in consumption of a good due to the increase of income ofthe consumer- Substitution effects of a price increaseo Substitution effect causes reduction in the quantity demanded of the now more expensive goodo Income effect (for a normal good) causes a further reduction in quantity demandedo Income effect (for an inferior good) causes an increase in quantity demanded; overall impact on consumption is not certaino If good is a “Giffin good” increase in price will cause consumption to go up- Price increase example: Gasoline Taxo Gasoline tax makes optimal consumption at point C (on curve U2) impossibleo Income and substitution effects bring consumer to point E (U1)o Rebate brings consumer back close to initial budget (at H) but not initial utility- Quick Note on Aggregating Market demando Market demand curve is the horizontal sum of individual demand


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