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Week 6 Notes

by: Eunice

Week 6 Notes PAM 2000


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Ordinary and Compensated Demand Elasticity Substitution and Income Effects
Intermediate Microeconomics
McDermott, E
Class Notes
Microeconomics, PAM
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This 4 page Class Notes was uploaded by Eunice on Saturday March 5, 2016. The Class Notes belongs to PAM 2000 at Cornell University taught by McDermott, E in Fall 2015. Since its upload, it has received 31 views. For similar materials see Intermediate Microeconomics in Political Science at Cornell University.

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Date Created: 03/05/16
PAM 2000 McDermott Spring 2016 March 1, 2016  Income and Substitution Effects o Substitution effect: change in consumption due to the relative change in the price only  as price of one good increases, the relative price of both goods change  consumer may substitute away from the more expensive good  towards the less expensive good o income effect: change in consumption due to the decrease in perceived income only o income and total(=income + substitution) effects results in 4 categories of goods  income effect  normal good: consumption increases as income increases  inferior good: consumption decreases when income increases  total effect (just substitution effect is uninteresting: consumer always substitutes away from the more expensive good)  Giffen good: consumption increases as price increases  ordinary good: consumption decreases as price increases  observing effects o compensate the consumer  allow consumption at the same utility level as before but with a new price ratio  price change pivots the budget constraint (changing the slope)  to compensate, find the point of tangency between the original/initial IC and a line of the same slope (the same price ratio) as the new BC  the shift/difference between the new BC and the theoretically shifted (to be tangent to the IC) one = compensation variable  what will observed  substitution effect: decrease in demand for x relative to the price increase, utility constant o assumes Py is constant and Px increases  income effect: change in demand for x due to decrease in purchasing power (Px increased) o using the new price ratio, comparing income required to buy the un-/compensated bundles o compensation variable: the amount of income that you have to compensate the consumer so that he or she is as happy as before (the shifting of the BC out to be tangent to the original IC)  see slide 13 (the combination of effects graphical)  compensated demand o Cobb-Douglas  consumer can substitute towards less expensive good with no utility change  as price increases the compensated consumer can afford more than an uncompensated one but the two have different amounts demanded  think of perfect complements o you can be at the same IC again thanks to compensation but without the exact same bundle (of left and right shoes for ex), you won’t be satisfied  compensated vs. ordinary demand o slide 13 o A and B are ordinary o C is at a point of compensated demand o slide 15  with Leontief, the utility doesn’t change as Px changes  thus the compensation behaves/influences demand differently  the demand function is a vertical line at a specific quantity of good x  slide 21  with Linear  the consumer’s utility as satisfied by compensation so the graph drops straight down to the x axis since more units of x would not increase utility  unlike ordinary demand where buying more units would increase utility (at a decreasing rate) o relevance  Leontief preferences and Social Security and COLA  cost of living adjustments o the ss admin uses the CPI-W (consumer price index for urban wage earners and clerical workers) o implicitly assumes consumers have Leontief preference  Leontief always yields a fixed optimal ratio of goods  change in income or prices does not affect this  ex. o typical ss recipient is similar to the representative who purchased the “representative” bundle of goods the CPI-W used  CPI-W: +%5 change in prices (inflation)  if the representative consumer is given a +5% COLA change  depends. March 3, 2016  Demand curves o compensated demand curve: Hicksian o ordinary demand curve: uncompensated, Marshallian  tends to underestimate change in CS (consumer surplus)  elasticities o the impact of a price increase (depending on how substitutable other goods are for the good at hand) o cross-price elasticities gives us a measure of how substitutable goods are o price elasticity of Demand  ε = %∆Q/%∆P = ((Q -Q )/Q )/((P -P )/P ) 2 1 1 2 1 1  extremely important for monopolists  price elasticity of demand will usually change as we move along the demand curve (even if it’s linear) o elastic: |ε| > 1 o inelastic: |ε| < 1  ε is closer to zero o unit elastic: if ε is -1 (|ε|=1)  assume ε is negative (not Giffen) o assuming the law of Demand holds  First Law of Demand: as price increases, demand decreases (vice versa)  not Giffen o income elasticity:  if income increases and consequently influences demand o complement vs. substitute  complement: price goes up on a complement, the other’s demand goes down  substitute: price goes up on a substitute, the other’s demand goes up  Armendariz preferences o Giffen goods o price of a good and its quantity demanded are positively correlated o


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