Ec2204 tutorial 6(1)
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Ec2204 tutorial 6(1)






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Ec2204 tutorial 6(1) Ec2204 tutorial 6(1) Presentation Transcript

  • Academic Year: 2012/2013Instructors: Brenda Lynch and PJ Hunt Contact:
  • Fig 9.1 Two goods, X and Y. Income fixed. Originalconsumer 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).
  • YI/Py Y1 A B Y2 IC0 IC1 X X2 I/Px X1 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 theincome effect by compensating the consumer justenough income to put him back on the originalIC0. 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.
  • Y Fig. 9.1 A to C = Substitution EffectI/Py C to B = Income Effect Y3 C Y1 A B Y2 IC0 IC1 X X2 I/Px x1 I/Px X3
  • Hicks and Slutsky.Inflation increases, how much do youcompensate 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 andtangential 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
  • Y r Fig. 9.2 sSlutsky Hicks r-t s–t t Slutsky Hicks C A B IC0 IC1 X I/Px I/Px