# MIT - Principles of Microeconomics - Unit 2. Consumer Theory - Lec 7. Applying Consumer Theory Labor

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PROFESSOR: All right. So today we are going to start by reviewing income and substitution effects. Because that's a pretty hard concept and pretty central to a lot of what we'll do for the rest of the semester.

And then we're going to dive in and talk about an application, a more interesting application, of income and substitution effects which is the effects of wages on labor supply.

So let's review. If you take the handout, grab the handout and look at the first figure, it's the same as the last figure of the previous lecture.

To review, remember, whenever the price changes, a price change can be decomposed into two effects, the substitution effect and the income effect. The substitution effect is the change in the quantity demanded when the price changes, holding utility constant.

And as we proved last time, that is always negative, 0 or negative. It is always non-positive. It's always true that when a price goes up, the substitution effect is negative.

We proved that both mathematically and graphically last time showing that if you're going to hold utility constant, and the price of a good is going to go up, you're going to shift away from that good. OK.

That's the substitution effect.

In our example, we showed graphically how you measure a substitution effect. You draw a new imaginary budget constraint, BC3, which is parallel to the new budget constraint, BC2. So it's got the new price ratio but tangent to the old indifference curve.

So the key thing to understand is the imaginary budget constraint, BC3, where it comes from. It's parallel to the new budget constraint. That is it's got the new marginal rate of transformation, the new slope, but it's tangent to the old indifference curve. That gets you to point B. And so the movement from A to B is the substitution effect.

Then we have an income effect which is, in fact, utility isn't held constant when prices change. In fact, utility falls, because you're effectively poorer. You're effectively poorer. Utility is falling. And since you're

effectively poorer, that further reduces demand if the good is normal.

So if it's a normal good, if it's a good where lower income causes less consumption of it, the fact that you're effectively poorer further lowers the consumption from point B to point C.

So the total price effect is the one we demonstrated at the beginning of the last lecture. We raised the price of movies from $8 to $12. And we saw the number of movies consumed fell from 6 to 4. But what we can see now to understand what's underneath that is two things, an effect of the fact that prices change holding utility constant, and the fact that you're effectively poorer.

And that's the key thing. No, your income hasn't actually gone down. But that $96 your parents gave you can buy you less. Your opportunity set has been restricted. And that makes you effectively poorer. And so you buy less for that reason. And so you get the total movement from A to C.

Now, as we emphasized last time, this will be the case if it's a normal good. So substitution effects are done. Substitute effects are always negative, nothing fun about that. Income effects are a little more interesting, because goods can be not normal but inferior.

We have inferior goods which are ones such that they're crummy stuff that as your income goes up, you want less of it.

And that can change the analysis. So if we look at Figure 7-2, now we're talking about the price change with an inferior good.

And then we're going to dive in and talk about an application, a more interesting application, of income and substitution effects which is the effects of wages on labor supply.

So let's review. If you take the handout, grab the handout and look at the first figure, it's the same as the last figure of the previous lecture.

To review, remember, whenever the price changes, a price change can be decomposed into two effects, the substitution effect and the income effect. The substitution effect is the change in the quantity demanded when the price changes, holding utility constant.

And as we proved last time, that is always negative, 0 or negative. It is always non-positive. It's always true that when a price goes up, the substitution effect is negative.

We proved that both mathematically and graphically last time showing that if you're going to hold utility constant, and the price of a good is going to go up, you're going to shift away from that good. OK.

That's the substitution effect.

In our example, we showed graphically how you measure a substitution effect. You draw a new imaginary budget constraint, BC3, which is parallel to the new budget constraint, BC2. So it's got the new price ratio but tangent to the old indifference curve.

So the key thing to understand is the imaginary budget constraint, BC3, where it comes from. It's parallel to the new budget constraint. That is it's got the new marginal rate of transformation, the new slope, but it's tangent to the old indifference curve. That gets you to point B. And so the movement from A to B is the substitution effect.

Then we have an income effect which is, in fact, utility isn't held constant when prices change. In fact, utility falls, because you're effectively poorer. You're effectively poorer. Utility is falling. And since you're

effectively poorer, that further reduces demand if the good is normal.

So if it's a normal good, if it's a good where lower income causes less consumption of it, the fact that you're effectively poorer further lowers the consumption from point B to point C.

So the total price effect is the one we demonstrated at the beginning of the last lecture. We raised the price of movies from $8 to $12. And we saw the number of movies consumed fell from 6 to 4. But what we can see now to understand what's underneath that is two things, an effect of the fact that prices change holding utility constant, and the fact that you're effectively poorer.

And that's the key thing. No, your income hasn't actually gone down. But that $96 your parents gave you can buy you less. Your opportunity set has been restricted. And that makes you effectively poorer. And so you buy less for that reason. And so you get the total movement from A to C.

Now, as we emphasized last time, this will be the case if it's a normal good. So substitution effects are done. Substitute effects are always negative, nothing fun about that. Income effects are a little more interesting, because goods can be not normal but inferior.

We have inferior goods which are ones such that they're crummy stuff that as your income goes up, you want less of it.

And that can change the analysis. So if we look at Figure 7-2, now we're talking about the price change with an inferior good.

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