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“This video session. We will look at income and substitution effects of a price science science in the chapter dealing with utility. We looked at the utility approach and indifference. If you can remember and we now focus on the difference approach.
We use indifference curves and budget constraints or budget lines to determine whether consumers in equilibrium. Now one of the major advantages of the indifference of road. So indifference curves analysis. Is that you can basically graphically analyze the income effect and the substitution effect of a price change.
So we re going to basically first look at you know the the two effects. See what is an income effect. And what is the substitution effect of a price change. We will focus on you know if the price of a product a certain product decrease and i placed on the moodle site you know this on notes on on this so please go to the chapter.
And there s some additional notes on this topic. So. What is important is that we can use you know the indifference curve analysis to analyze graphically analyze the income effect and the substitution effect of a price change so let s assume that the price of a good decrease. Now yeah whatever what will happen now when the price of a good falls right and the price of all other goods remain constant and also if consumers you know the price of all other goods remain constant and also the nominal income.
There is a money income of a consumer remain constant. What is the effect on the real income of a consumer. And that is the income effect. No real income means basically you know what can you buy with your your money how much goods and services.
You can buy and you know over the last couple of years because of inflation rate. Increasing real income has been declining yeah our nominal income of salaries haven t been keeping up with our with inflation so if inflate. If the price of a good decrease. What will then happen with our real income under the assumption that prices of all other goods remain constant.
And the nominal income of consumers or also the money income remain also constant. So what will happen with the real income if prices decrease. It means that in fact is that because real income will definitely increase because now week. The price has decreased.
So the consumer can buy more of this good here in comparison with other goods. Because the prices of other goods has remains constant so really income has increase and in because of real income and we assume that we are only dealing with normal goods. We know they are normal goods and inferior goods. But we will only focus on normal goods and i will only test you in the taste.
So in the exam on a normal good. So..
If the price goes down of a normal good. What happens you know of the quantity. Demanded of that good will increase and because of what because of the real income has increase. So basically there will be an increase in the consumption of this good so good x whatever right and that good is a normal good not an inferior good so this is the income effect of a price of science.
Remember we only focus on the price decrease a price increase can also be done. But i will only test you on the price decrease. Now that is the income effect of a price reigns now again is the price of the product decrease. What is the substitution effect.
If the price of a product decrease are a little to other products. Then it means that and other products prices remain the same then what is the sum or the conclusion that we can draw from that is that you know this product becomes in relatively cheaper than other products. So if this product becomes valid relatively cheaper than other products in what if equally to f on. You know the consumption or the the purchases of this good so it means that say for example.
There are two products bread and and meat. So say for example. If the price of say if you look at the price of meat as decrease. What will then happen.
The consumer will buy more meat and less bread. Because the price of bread has has gone or meat has gone down let s look at the example. And then the other product is bread so relative to bread. The price of meat as decrease.
And then meat becomes a little bit cheaper than bread. So what will the consumer. They do you will substitute meat for bread. And that is a substitution effect.
Because of the price decrease right so this are the three fix that you know price decrease can have and then basically if you go back to the first one because of the income. The real income increasing the consumer will buy more meat for example and because of the price of meat coming down relative to bread. The consumer will also buy more meat. Which is a normal good right okay so out of this price decrease.
They will be greater consumption of meat taking place right. So. What i ve done now is explained. The income and the substitution effect of a price change now the advantage of indifference curves analysis is that we can we know the prices decrease.
And what does happen now with the quantity demanded or meat has increase. This is meat because of the income effect..
That is the real income as increase and because of the substitution effect. Okay because meat becomes relatively cheaper than then bread. So this whole income and substitution effect. This is what we call the price effect.
The old price effect and basically what happens is that the quantity demanded as increase more meat will be purchased because of this okay now what this analysis you know able us to do or did we can now graphically split separate. The income effect and the substitution effect of a price science. All of this decrease in the price we can do it graphically now this one is a bit complicated for students. So what i m going to do.
It is also in the distal notes. You will find a diagram day. So we start off with a diagram and then what we miss on the horrid on the vertical axis is the quantity of bread. So that is bread okay.
So the quantity of bread is on the vertical axis and in the quantity of meat so we can say q m or q b ok quantity bread quantity meat okay so where do we start of we going to use now budget lines and indifference curves to separate the income and the substitution effect of this price decrease or price change. So where do we start off. We start off with your regional budget line. We draw the original budget line right okay.
Now lets you know label the original budget line. That is q bread and q. Meat. So that is your original budget line right and then you know the consumer you know ways to consume in equilibrium where the highest indifference curve is tangent to the budget line so in this example we draw an indifference curve okay.
Which is tangent to the budget line and in the distal note so they use you. But let s use i so. That is indifference curve one. So where the the is indifference curve is tangent to the budget.
Constraint or the budget line. Say at this point. That will be point a now in terms of where we started of the original budget line tangent the touching tangent means touching the highest indifference curve at this point. The consumer is in equilibrium.
This is where we start off right okay. Now let s suppose that the price. The price of meat decreases. Okay now what effect will this have on the budget line and remember in previous video sessions.
We we mentioned and we illustrate if there is a change in the price of the product or the you know in the income of the consumer. What will happen with the budget line now if the price of meat falls right..
What will happen with the budget line and that is basically you know you know what will happen with the consumers indifference curve. So if you look at the original budget line. Because of the the price of meat has fallen. What will happen now with the budget line.
It will swivel outwards. So you have to draw now remember the consumer will now buy more meat okay so rate remains constant so there will be more meat that will be bored by the consumer. So you have to draw it you know it will start there. And then that will be your your new budget line its swivel to the right because there is more meat that will not be pu.
So manufacturing kind of similarities here all those production not just manufacturing capacity utilization is if the capacity is at full steam basically are how much capacity has been utilized in the manufacturing sector. So are they running really really low and they ve got some loads of spare capacity are they running a flat out again just kind of a little bit of a thermometer on the health of the economy and this is not these aren t gonna shift currency pairs too much unless we have something really extreme and we started getting some ones here which are you know kind of less of an impact on the market not so much job claims comes down a second. But these unless something specific perhaps. People are worried about manufacturing sector as a whole.
And it s been something that traders have been watching for example. We know gone through. Though just cycles throughout the years and you see traders focusing on specific angles. Hey the recovery manufacturing is stalling the chronic growth.
If that s the story then all of a sudden these kind of numbers will come in to people s radar. They ll be watching a lot more like if we ran interest rate cycle. We re about to you know it lifts. The interest rates up and people are starting going to look at that if forgotten unemployment.
The people s envision moves so a kind of trick that you can do without going. Too deep into the economics of all this kind of stuff just to go onto your bloomberg. Your roi to see what traders are looking at why if there s a lot of story about hey you know manufacturing is really important. The moment because this isn t this then you need to make sure you re watching these data points.
That come out there are relating to manufacturing. If no one cares about it you gotta have only a radar. You don t get caught out by spiteful stops. You re out in a trade.
But you have to worry about it too much all right i mean what we ve got retail sales pretty self explanatory guys retail sales is oh actually it s more properly known as the advanced monthly sales for retail traders. A report. Which basically just gives us you know. When is it come out as a division of the us department of commerce and they report every two weeks after the month in question.
So i thought it was every two weeks. Almost i m quite sure whether it was only two weeks..
Very month on this one but retail sales pretty much self explanatory guys. It s just the indication of how much people are buying in terms of read sales. If it s increasing economic health is picking up people are spending more people are driving more money into the economy creates more jobs. Quite small profits quit.
Some of corporation to make more money. If retail sales are picking up as well obviously if you re trading retail stocks you might get some kickback from that in terms of hey. There next earnings are going to be good because the retail sales are up etc etc etc okay durable goods orders this is our reached by the census bureau as part of the us department of commerce let s get some juicy information. It is basically google goods are defined as items that have expected to last for at least three years so these are kind of expensive items that are bought infrequently.
Okay. So not something that s repairable. But you know expensive purchases that people will buy not very often but they all got a reasonable life cycle. And that s kind of the reason is because if the demand is strong then it means people are again willing to spend willing to kind of put more out into the economy.
Which could have a lock on effect to the overall economy and could increase things if you see a sharp slowdown and stuff. Like that then you know it might be a warning sign that things could be on the downturn that will affect the us dollar that will affect the currency pairs you were trading all right finally guys. Initial jobless claims this is comes out weekly comes out of thursday every week and it s for people making first time claims for unemployment benefit in assurance. This is a good one because it comes out so regularly that you know in the paper.
When the kind of jobless sector is in focus the unemployment employment rate that job market is in focus you get a regular update of this as opposed to non farm payrolls. Which is kind of once a month this is coming out weekly and so give you short term data into the changes of the labor market and this is this interesting. Because often you ll get kind of spikes. Unusual spikes and and declines that are out know it because weekly.
Because it kind of doesn t dampen out as much thinking like a moving average on your chart. It s kind of they re printing printing printing. You often get some surprise move so that s well worth watching you know when things are stable and stuff you re going to get their oscillations. But every now and then when we re kind of at the psyche where it s cycle turns and we re kind of unknown places in the economic cycle.
Then that s when this jobless claims number does have an impact and you to prepare yourself as a trader. You re either going to be out of your position. You re going to be prepared to kind of capture those spikes and falls with limit orders or you re gonna set back wait for a maybe a trend to resume that kind of stuff so those are 11 economic indicators that potentially impact the currency market big ones in the beginning cover lesser ones at the end. But all will move if they are out of line of what s expected that s the key thing you guys about man.
And what the bean decatur size is obviously the bigger indicator. If it moves a lot out of what they ve expected you re gonna get massive moves in the currency market. If it doesn t you re going to get kind of a little bit of oscillation while people pull the quiddity out and then it calms down and we re off the races again and we re back to normal market conditions alright guys. Till next time take care bye bye.
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