Economists, I told my class, are the most empathetic and tolerant of people. Empathetic, as they learnt from game theory, because they strive to see the world through the eyes of others. Tolerant, because they never question anyone’s preferences. If I had the talent I’d have broken into song with a version of `Why Can’t a Woman be More Like a Man’ :
Psychologists are irrational, that’s all there is to that!
Their heads are full of cotton, hay, and rags!
They’re nothing but exasperating, irritating,
vacillating, calculating, agitating,
Maddening and infuriating lags!Why can’t a psychologist be more like an economist?
Back to earth with preference orderings. Avoided the word rational to describe the restrictions placed on preference orderings, used `consistency’ instead. More neutral and conveys the idea that inconsistency makes prediction hard rather that suggesting a Wooster like IQ. Emphasized that utility functions were simply a succinct representation of consistent preferences and had no meaning beyond that.
In a bow to tradition went over the equi-marginal principle, a holdover from the days when economics students were ignorant of multivariable calculus. Won’t do that again. Should be banished from the textbooks.
Now for some meat: the income and substitution (I&S) effect. Had been warned this was tricky. `No shirt Sherlock,’ my students might say. One has to be careful about the set up.
Suppose price vector and income
. Before I actually purchase anything, I contemplate what I might purchase to maximize my utility. Call that
.
Again, before I purchase , the price of good 1 rises. Again, I contemplate what I might consume. Call it
. The textbook discussion of the income and substitution effect is about the difference between
and
.
As described, the agent has not purchased or
. Why this petty foggery? Suppose I actually purchase $x$ before the price increase. If the price of good 1 goes up, I can resell it. This is both a change in price and income, something not covered by the I&S effect.
The issue is resale of good 1. Thus, an example of an I&S effect using housing should distinguish between owning vs. renting. To be safe one might want to stick to consumables. To observe the income effect, we would need a consumable that sucks up a `largish’ fraction of income. A possibility is low income consumer who spends a large fraction on food.
4 comments
November 5, 2014 at 2:12 pm
taips
I think the Slutsky equation we teach should have an endowment term, even if we make it zero in some applications
It’s not more complicated, we need it to apply I&S effects in a consumption-leisure tradeoff anyway, or in general equilibrium.
Textbooks describe Giffen goods by taking the example of people near subsistance levels and food, but people near subsistance level are often subsistance farmers, so discussing the reaction of their (net) trade to a price increase by treating their budget as independent of price are a little odd.
November 9, 2014 at 10:08 pm
rvohra
Yes, I plan to cover Slutsky with fingers crossed!
November 6, 2014 at 2:44 pm
Luca
I don’t know if you plan to talk about it, but I&S effects are easier after one describes Hicksian demand. Then, you go from x to z via a y that solves a related problem… maybe a good idea, maybe not. If you plan to talk about duality… definitely a good idea.
November 9, 2014 at 10:05 pm
rvohra
Dear Luca
Yes, thanks, planned to do Hicksian demand.