Tuesday, January 17, 2006

Income and Substitution Effects


How do I know when I need to talk about the income and substitution effects?


Generally, you need to think about income and substitution effects when thinking about changes in consumption. This could be a price change of a good, a change in wage (if talking about supply of labor and consumption of leisure), or change in interest rate (if talking about supply of capital and consumption in year 1).

If a problem asks about change in consumption as a result of change in income, you need to only consider the income effect.


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