ECONOMIC PRINCIPLES

Economic principles

Economic Principles

Introduction

Reduction or increase in the price of a commodity affects the volume of demand through the substitution effect and income effect. The effect of substitution causes an increase in consumption relatively cheapened commodity, whereas the income effect may stimulate and increase and decrease consumption of the goods or be neutral. In order to determine the effect of replacing the need isolate the impact of the income effect (Groenewegen, 1977, pp.56-59).

There are two approaches to the definition of real income associated with the names of the English economist John Hicks and the Russian mathematician and economist E. Slutsky.

According to Hicks, different levels of monetary income, providing the same level of satisfaction, ie allow to reach the same indifference curve, represents the same level of real income.

According to Slutsky, only the level of monetary income this is sufficient for the acquisition of one and the same set or combination of products, and provides a constant level of real income.

Hick's theory keeping with the basic provisions of ordinal utility theory, "while the Slutsky approach has the advantage that it allows a quantitative solution to the problem on the basis of statistics." We first consider the version proposed by Hicks, as a more general one.

Substitution Effect and Income Effect

In economics is not only relevant to know what the behavior of agents in certain circumstances is, but also know how to vary such behavior to changes in the environment. What will be the quantity demanded of some good to changes in the price? What effects will a change in wages on the number of jobs offered? How to change my savings if you change the rate of interest?

Change in the price of an asset can observe these two effects varies both the rate at which can be exchanged ("replace") one good for another as the power purchasing our total income. The variation in the quantity demanded by a variation of the terms of trade between the two assets is called the substitution effect or price, while the change in demand caused by a change in purchasing power is called the income effect or income (Varian, 1992, pp.120-125).

Substitution Effect and the Slutsky Hicks

There are two ways to see the substitution effect. If we consider the Slutsky, we are talking about the variation in demand when vary prices, holding constant the initial purchasing power. If we consider it to Hicks, we are talking about the variation in demand when prices change, remaining at the same level of utility, ie, the same indifference curve. In this paper, we limit ourselves only to develop the analysis based on the position of Hicks.

Deriving the Slutsky equation in consumer theory:

As said earlier, what matters knows what the new balance when we change the environment that determines it. Therefore, we find the equilibrium conditions of the system and then differentiate. By doing this, we will see what the change in variables consumer decision they vary the data that determine ...