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Unformatted text preview: Chapter 8 Wealth and Substitution Effects in Labor and Capital Markets In Chapter 7, we introduced the concepts of income and substitution effects in models where income enters the consumer’s optimization problem exogenously — i.e. where consumers are choosing to allocate a fixed money budget across consumption goods. 1 We now turn to cases where income is endogenous — where our consumption is funded not by a fixed money budget but rather by the sale of something that we own. This can happen in consumer goods markets if we own one of the goods that is part of the analysis. More importantly, as we illustrated in some detail in Chapter 3, it happens in labor markets where we sell our leisure time and in capital markets where we buy and sell financial assets as we plan for the future. The analysis in this chapter in one sense is no different than that in Chapter 7 – we will again look at changes in behavior that result from changes in opportunity costs (i.e. substitution effects) and changes that happen as a result of “real income” having changed. At the same time, some important differences emerge – differences in the analysis that are in the end quite intuitive. When the price of gasoline increases, we would always expect the substitution effect to indicate that we will consume less gasoline. But whether the price increase makes us better off (and thus increases our “real” income) or whether it makes us worse off (and thus decreases our “real” income) depends on whether we own an oil well. Most of us don’t – and thus most of us become worse off when gasoline prices increase. In the language of Chapter 7, we experience a negative income effect (that will lead to a further decrease in our gasoline consumption if gasoline is a normal good). But if you own an oil well, the increase in gasoline prices probably makes you better off – because what you own just became more valuable. Thus, you would experience a positive income effect – one that will lead you to increase your consumption of gasoline if gasoline is a normal good. 8A Wealth Effects, Substitution Effects and Endowments In Chapter 7, we adopted the term “income effect” for the impact of parallel shifts in budget constraints on consumption behavior. Such effects occurred either because the fixed money income within the models we dealt with changed directly, or because the “real” income changed as a 1 Chapters 2 through 7 are required reading for this chapter. 222 Chapter 8. Wealth and Substitution Effects in Labor and Capital Markets result of a price change. We now turn to the case where the change in the price of a good has a different effect because it changes the value of something we own and thus alters our budget constraint differently than it did in Chapter 7. We will call the new effect that emerges a “wealth effect” because it captures the change in wealth a consumer experiences when prices change and thus affects the value of what the consumer owns. As we will see, the substitution effect remainsthus affects the value of what the consumer owns....
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