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Microeconomics: Income and Substitution Effects

by Manuel Salas Velasco on Feb 08, 2011

Consumer Behavior: Income and Substitution Effects ...

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1 comment Notes on Slide 26

11 of 1 comment

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dipteedkThe last table illustrating both effects for the different goods is really interesting -

but how would such an illustration for a superior good differ from that of a normal one ?6 months

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Microeconomics: Income and Substitution EffectsPresentation Transcript

1. Microeconomics Consumer Behavior: Income and Substitution Effects Dr. Manuel Salas Velasco

2. The Budget Constraint Dr. Manuel Salas Velasco vertical intercept horizontal intercept Slope The equation for the budget line: Relative price ratio Budget set The budget set consists of all bundles that are affordable at the given prices and income

3. The Consumers Utility Maximizing Choice Dr. Manuel Salas Velasco E The consumers utility is maximized at the point (E) where an indifference curve is tangent to the budget line The condition for utility maximization: X* Y* (X*, Y*) is the utilitymaximizing bundle The optimum quantities (X*, Y*) obtained by solving the Lagrangean problem tell us how much of each good an individual consumer will demand, assuming that he/she behaves rationally and optimizes his/her utility within his/her budget.

4. Consumer Behavior The Consumers Reaction to a Change in Income Dr. Manuel Salas Velasco

5. Shifts in the Budget Line Dr. Manuel Salas Velasco M = 20; P X = 2; P Y = 1 M = 10; P X = 2; P Y = 1 Prices are held constant and income increases (e.g. the consumers income doubles) M >M

6. Response to Income Changes Dr. Manuel Salas Velasco Y X Income-Consumption Curve E 1 E 2 E 3 X, Y, normal goods Prices are held constant Income increases: M 1 < M 2 < M 3 Increases in money income cause a parallel outward shift of the budget line The utility-maximizing point moves from E 1 to E 2 to E 3 By joining all the utility-maximizing points, an incomeconsumption line is traced out

7. How Consumption Changes as Income Changes Dr. Manuel Salas Velasco M Y Engel Curve for good Y, with good Y as normal M 1 M 2 M 3

8. Engel Curve or Engels Law A general reference to the function which shows the relationship between various quantities of a good a consumer is willing to purchase at varying income levels ( ceteris paribus ) Dr. Manuel Salas Velasco Ernst Engel (1821-1896) A German statistician who studied the spending patterns of groups of people of different incomes People spent a smaller and smaller proportion of their incomes on food as those incomes increased

9. Consumer Behavior The Consumers Reaction to a Change in Price Dr. Manuel Salas Velasco

10. Shifts in the Budget Line Dr. Manuel Salas Velasco M = 10; P X = 2; P Y = 1 M = 10; P X = 1; P Y = 1 Decrease in the price of X (50%)

11. Response to Changes in a Goods Price Dr. Manuel Salas Velasco Y X Price-Consumption Curve E 1 E 2 E 3 Decrease in the price of X: Price of Y and income are held constant: > >

12. How Consumption Changes as Price Ratio Changes Dr. Manuel Salas Velasco Quantity, X Price of X Demand Curve for X

13. The Consumers Demand Function Dr. Manuel Salas Velasco We are interested in finding the individual demand curve for the good X; an expression for quantity demanded as a function of all prices and income The condition for utility maximization is: U = U (X, Y) Lets suppose that the utility function is: U = X Y + X + Y

14. The Consumers Demand Function Dr. Manuel Salas Velasco P X X + P Y Y = M X = X (P X , P Y , M) Consumers demand function (generalized demand function)

15. The Own-Price Demand Dr. Manuel Salas Velasco M = $100; P Y = $10 Consumers demand function The own-price demand curve (ordinary demand function for X): X = f (P X ), ceteris paribus Suppose we use the following parametric values: However, economists by convention always graph the demand function with price on the vertical axis and quantity demanded on the horizontal axis The inverse demand function P X X

16. The Engel Curve Dr. Manuel Salas Velasco P X = $5; P Y = $10 Consumers demand function The Engel curve for X If Income Elasticity is positive, then X is a normal good (quantity demanded increases as income increases, ceteris paribus ) Suppose we use the following parametric values: X is a normal good

17. The Cross-Price Demand Curve Dr. Manuel Salas Velasco P X = $5; M = $100 Consumers demand function Suppose we use the following parametric values: Cross-price demand curve for X We hold the own price of good X and money income constant; we focus on the relationship between the quantity demanded of good X and the price of good Y If CPE is positive, then X,Y are substitutes If CPE is negative, then X,Y are complements X is a substitute for Y

18. Cobb-Douglas Utility Function Dr. Manuel Salas Velasco The condition for utility maximization is: U = U (X, Y) P X X + P Y Y =

M Consumers demand function for X The utility function is: P X = 4; M = 800; P Y = 1 X* = 100 units

19. Consumer Behavior Income and Substitution Effects Dr. Manuel Salas Velasco

20. The Income Effect and the Substitution Effect of a Price Change Dr. Manuel Salas Velasco Quantity, X Price of X OwnPrice Demand Curve for X (Inverse Ordinary Demand Function for X) When price of good X falls, the optimal consumption level (or quantity demanded) of good X increases What are the underlying reasons for a response in the quantity demanded of good X due to a change in its own price? Substitution effect : the impact that a change in the price of a good has on the quantity demanded of that good, which is due to the resulting change in relative prices (P X /P Y ) Income effect: the impact that a change in the price of a good has on the quantity demanded of that good due strictly to the resulting change in real income (or purchasing power) Total effect

21. Income and Substitution Effects Dr. Manuel Salas Velasco Y X Price of Y and monetary income are held constant: Decrease in the price of X: > E 1 E 2 TE SE total effect (TE) = substitution effect (SE) + income effect (IE) IE

22. The Substitution Effect: Two Definitions in the Literature Dr. Manuel Salas Velasco Eugene Slutsky 1880-1948 Sir John R. Hicks 1904-89 The Slutsky substitution effect The Hicks substitution effect The effect on consumer choice of changing the price ratio, leaving his/her initial utility unchanged The effect

on consumer choice of changing the price ratio, leaving the consumer just able to afford his/her initial bundle

23. The Slutsky Substitution Effect Dr. Manuel Salas Velasco Y X Price of Y and monetary income are held constant: Decrease in the price of X: > E 1 E 2 E 3 We do this by shifting the line AB to a parallel line CD that just passes through E 1 (keeping purchasing power constant) To remove the income effect, imagine reducing the consumers money income until the initial bundle is just attainable A B C D Although is still affordable, it is not the optimal purchase at the budget line CD The optimal bundle of goods is: SE IE TE X is a normal good

24. The Slutsky Substitution Effect Dr. Manuel Salas Velasco Y X E 1 E 2 E 3 A B C D E 1 : Change ( reduction ) in money income necessary to make the initial bundle affordable at the new prices M= amount of money income that will just make the original consumption bundle affordable: E 3 : SE IE TE X is a normal good

25. Example Dr. Manuel Salas Velasco The individual demand function for milk is: Consumers income is $120 per week and P X is $3 per quart: Lets suppose that the price of milk falls to $2 per quart: The total change (total effect): Level of income necessary to keep purchasing power constant The substitution effect is: The income effect is: 0.7 (16 15.3)

26. The Hicks substitution effect Dr. Manuel Salas Velasco Y X > E 1 E 2 E 3 To remove the income effect, imagine reducing the consumers money income until the initial indifference curve is just attainable We do this by shifting the line AB to a parallel line

CD that just touches the indifference curve U 1 (the utility level is held constant at its initial level) A B C D SE IE TE The intermediate point E 3 divides the quantity change into a substitution effect (SE) and an income effect (IE) X is a normal good

27. Income and Substitution Effects: Inferior Good Dr. Manuel Salas Velasco E 1 E 2 E 3 Y X > A B C D substitution effect income effect total effect The consumer is initially at E 1 on budget line AF F With a decrease in the price of good X, the consumer moves to E 2 ; the quantity of X demanded increases (total effect) The total effect can be broken down into: A substitution effect (associated with a move from E 1 to E 3 ) An income effect (associated with a move from E 3 to E 2 ) X is an inferior good The substitution effect exceeds the income effect, so the decrease in the price of good X leads to an increase in the quantity demanded

28. Income and Substitution Effects: The Giffen Good Dr. Manuel Salas Velasco E 1 E 2 E 3 Y X > A B C D substitution effect income effect total effect The consumer is initially at E 1 on budget line AF F With a decrease in the price of good X, the consumer moves to E 2 ; the quantity of X demanded decrease (total effect) The total effect can be broken down into: A substitution effect (associated with a move from E 1 to E 3 ) An income effect (associated with a move from E 3 to E 2 ) X is a Giffen good The income effect exceeds the substitution effect, so the decrease in the price of good X leads to a decrease in the quantity demanded

29. Income and Substitution Effects of a reduction in price of good X holding income and the price of good Y constant Dr. Manuel Salas Velasco Good X is: Substitution effect Income effect Total effect Normal Increase Increase Increase Inferior (not Giffen) Increase Decrease Increase Giffen (also inferior) Increase Decrease Decrease
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