32. Income and Substitution Effects
Impact of a price change is separated into two components: the substitution effect; and the income effect.
The substitution effect involves the substitution of good x1 for good x2 or vice-versa due to a change in relative prices of the two goods. It is results from the associated change in the relative attractiveness of other goods. Even if the individual remained on the same indifference curve when the price changes, his optimal choice will change because the MRS must equal the new price ratio.
The income effect results from an increase or decrease in the consumer’s real income or purchasing power as a result of the price change. The price change alters the individual’s “real” income and therefore he must move to a new indifference curve. So this is results from the associated change in real purchasing power. The decomposition of the price effect into the income and substitution effect can be done in several ways. There are two main methods:
According to The Hicksian method:
I
n
the case of decreasing price of X-good
In the case of increasing of the H-good price
If a good is normal (as in both cases), substitution and income effects reinforce one another:– when price falls, both effects lead to a rise in quantity demanded;– when price rises, both effects lead to a drop in quantity demanded.
If a good is inferior, substitution and income effects move in opposite directions. The combined effect is indeterminate:– when price rises, the substitution effect leads to a drop in quantity demanded, but the income effect is opposite;– when price falls, the substitution effect leads to a rise in quantity demanded, but the income effect is opposite.
If the income effect of a price change is strong enough, there could be a positive relationship between price and quantity demanded: – an increase in price leads to a drop in real income;– since the good is inferior, a drop in income causes quantity demanded to rise. This is the issue of Giffen’s Paradox.
The slutsky method
Slutsky claimed that if, at the new prices, less income is needed to buy the original bundle then “real income” has increased and more income is needed to buy the original bundle then “real income” has decreased.
To isolate the substitution effect we adjust the consumer’s money income so that s/he change can just afford the original consumption bundle. In other words we are holding purchasing power constant.
Draw a line parallel to the new budget line which passes through the point Ea. The new optimum on I3 is at Ec. The movement from Ea to Ec is the substitution effect.
The remainder of the total price effect is the Income Effect. The movement from Ec to Eb.
33. The process of production and it’s objective
Production is the process of altering resources or inputs so they satisfy more wants. Production, more specifically, the technology used in the production of a good (or service) and the prices of the inputs determine the cost of production. Within the market model, production and costs of production are reflected in the supply function. Production processes increase the ability of inputs (resources) to satisfy wants by: – a change in physical characteristics;– a change in location;– a change in time;– a change in ownership.
As we know consumers or buyers wish to maximize their utility or satisfaction given (or constrained by) their incomes, preferences and the prices of the goods they may buy. The behavior of the buyers or consumers is expressed in the demand function.
The producers and/or sellers have other objectives. Profits may be either an objective or constraint. As an objective, a producer may seek to maximize profits or minimize cost per unit. As a constraint the agent may desire to maximize “efficiency” market share, rate of growth or some other objective constrained by some “acceptable” level of profits.
All firms must make several basic decisions to achieve what we assume to be their primary objective – maximum profits:1.How much output to supply;2.Which production technology to use;3.How much of each input to demand.
The costs of production (Total Cost, TC) must be less than the revenues (Total Revenue, TR). “Determining the optimal method of production”:
When considering the production-cost relationships it is important to distinguish between such production units as firms and plants.
A plant is a physical unit of production. The plant is characterized by physical units of inputs, such as land (R) or capital (K). This includes acres of land, deposits of minerals, buildings, machinery, roads, wells, and the like.
The firm is an organization that may or may not have physical facilities and engage in production of economic goods. In some cases the firm may manage a single plant. In other instances, a firm may have many plants or no plant at all.