CENTRE FOR POLICY STUDIESUNIVERSITY COLLEGE CORK

EC2204TUTORIAL 6

W\S 19\11\2012

Academic Year: 2012/2013 Instructors: Brenda Lynch and PJ Hunt

Contact: brendalynch@ucc.ie p.hunt@ucc.ie

Fig 9.1 Two goods, X and Y. Income fixed. Original consumer equilibrium is at X1, Y1 (Point A).

Price of X increases, the budget line

rotates inward on the X axis and the new consumer equilibrium is at X2, Y2 (point B).

Y

I/Py

X

X1 I/Px

Y2

Y1

A

B

IC1

IC0

X2 I/Px

This drop in utility is caused by; (a) The income effect and (b) The substitution effect.

(a) An increase in the price of X is like a drop in real income.

(b) The substitution effect is the adjustment of demand to a change in the relative prices of goods as a result of a change in the price of one of the goods.

To isolate the substitution effect, remove the income effect by compensating the consumer just enough income to put him back on the original IC0.

Do this by drawing a line tangential to IC0 and parallel to new budget line. New intersect is at X3, Y3 (Point C).

The income effect reduces consumption of X from X3 to X2; the substitution effect reduces consumption from X1 to X3.

I/Py

X

Y2

Y1

A

B

IC1

IC0

C

X3

Y3

A to C = Substitution EffectC to B = Income Effect

Fig. 9.1Y

x1I/Px I/PxX2

Hicks and Slutsky. Inflation increases, how much do you compensate workers?Two ways (we only look at one way);

1. Compensation Variation in Income

Hicks, compensate workers at new prices to allow them obtain original level of utility.

Slutsky, compensate workers at new prices to obtain original bundle of goods.

Fig. 9.2 – Compensation Variation

Original consumer equilibrium at point A. Price of one good doubles, budget line pivots inward. New consumer equilibrium is at point B.

Hicks. Draw line parallel to new budget line and tangential to IC0 i.e. original utility on original IC. Compensation Variation = S –T

Slutsky. Draw line parallel to new budget line and tangential original consumer equilibrium i.e. original bundle of goods. Compensation Variation = R-T

X

I/Px

A

B

IC1

IC0

C

r - t s – tSlutsky Hicks

Fig. 9.2Yrs

t

Slutsky

Hicks

I/Px