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Lecture 7: Theory of the Consumer Income and Substitution Effects

The substitution effect The income effect The Slutsky identity The Law of Demand Examples The Hicks substitution effect Compensated demand curves

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There are two sorts of effects of a price change:

Rate of exchange between the two goods are altered Total purchasing power of your income has been altered

Substitution effect change in demand due to the change in the rate of exchange between the two goods Income effect the change in demand due to having more purchasing power.

Consumers budget is y.

x2

y p2

Original choice

x1

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Consumers budget is y. x2 Lower price for commodity 1 pivots the constraint outwards.

y p2

x1

Consumers budget is y.

x2

y p2 y' p2

Lower price for commodity 1 pivots the constraint outwards. Now only y are needed to buy the original bundle at the new prices, as if the consumers income has increased by y - y. Changes to quantities demanded due to this extra income are the income effect of the price change x1

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We analyze each effect in two steps:

Let relative prices change and adjust money income in order to hold purchasing power constant Let purchasing power adjust while holding relative prices constant

Analysis can proceed by pivot-shift of the budget line. Pivot the budget line around the original demanded bundle so that relative prices have changed (i.e., same slope as the new budget line) Shift this budget line outward so that the purchasing power changes slope stays constant but purchasing power has changed

Slutsky isolated the change in demand due only to the change in relative prices by asking What is the change in demand when the consumers income is adjusted so that, at the new prices, she can only just buy the original bundle?

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x2

x2

x1

x1

x2

x2

x1

x1

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x2

x2

x1

x1

x2

x2 x2

x1

x1

x1

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x2

x2 x2

x1

x1

x1

x2

Lower p1 makes good 1 relatively cheaper and causes a substitution from good 2 to good 1.

x2 x2

x1

x1

x1

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x2

Lower p1 makes good 1 relatively cheaper and causes a substitution from good 2 to good 1. (x1,x2) (x1,x2) is the pure substitution effect.

x2 x2

x1

x1

x1

Economic interpretation of the pivoted line: the substitution effect While relative prices are the same as in the final budget line, the money income is associated with it is different since the intercepts are different. Purchasing power is held constant since the original bundle of goods is just as affordable at the new pivoted line

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How much should money income be adjusted in order to keep the old bundle just as affordable?

Let y amount of money income that will just make the original consumption bundle affordable, ' ' ( x ' , x ' ) is affordable at both ( p1, p2 , y ) and ( p1 , p2 , y)
1 2

Therefore:

y ' p1' x'1 p2 x'2 y p1 x'1 p2 x'2

The change in money income necessary to make the old bundle affordable at the new prices is just the original amount of consumption of good 1 times the change in prices. This is derived by subtracting the second equation from the first:

y ' y x'1 [ p1' p1 ] y x'1 p1

Change in income and change in price will move in the same direction.

If the price goes up, then we have to raise income to keep the same bundle affordable. If prices go down, then income should be reduced to keep the old bundle of goods affordable

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The movement from bundle X to X is known as the substitution effect. It indicates how the consumer substitutes one good for the other when a price changes but purchasing power remains constant the substitution effect, x1s , is the change in demand for good 1 when the price of good 1 ' changes to p1 at the same time that money changes to y:

x1s x1 ( p1' , y ' ) x1 ( p1 , y)

To estimate the substitution effect, we use the consumers demand function to calculate choices at

( p1' , y ' ) and ( p1 , y)

Example: Suppose a demand function of the form:

x1 10

y 10 p1

At income = P120 and p1 = 3, original demand will be 14. Suppose price falls to 2, the new demand will be 16. Total change in demand is 2.

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To calculate substitution effect, calculate how much income would have to change in order for the original bundle to be affordable: The level of money income to keep purchasing power constant is:
y' y y 120 14 106

y x1p1 14 (2 3) P14

The consumers demand at this income and new ' price is: x1( p1 , y' ) x1(2,106) 15.3 The substitution effect is:

s x1 x1(2,106) x1(3,120) 15.3 14 1.3

The substitution effect is sometimes called the change in compensated demand. The consumer is being compensated for a price change by having his income changed so that he is able to afford his old consumption bundle.

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Shift movement is the income effect. This change moves us from the point X to X.

Change income while keeping prices fixed at the new prices. n The income effect, x1 , is the change in

demand for good 1 when we change income from y to y, holding the price of good 1 fixed at p1.

x2

x2 x2

(x1,x2)

x1

x1

x1

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x2

The income effect is (x1,x2) (x1,x2).

x2 x2

(x1,x2)

x1

x1

x1

x2

The change to demand due to lower p1 is the sum of the income and substitution effects, (x1,x2) (x1,x2). (x1,x2)

x2 x2

x1

x1

x1

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Income effect can operate either way:

If good is normal, decrease in income will lead to a decrease in demand

If good is inferior, decrease in income will lead to an increase in demand.

Calculating the income effect:

In the previous example we saw that:

' x1( p1 , y ) x1(2,120) 16 ' x1( p1 , y ' ) x1(2,106) 15.3

Thus the income effect is:

n x1 x1(2,120) x1(2,106) 0.7

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The substitution effect is negative

If the price of good 1 decreases, then the change in the demand for good 1 must be nonnegative: If
' ' s p1 p1 , then, x1( p1 , y1 ) x1( p1 , y ), so that, x1 0

If the consumer is choosing the best bundle that he can afford, then X must be preferred to all of the bundles on the part of the pivoted budget line that lies inside the original budget set. This means that the optimal choice on the pivoted budget line must not be one of the bundles that lie underneath the original budget line. Optimal choice should be X or something to the right of X. This means that the new optimal choice must imply consuming at least as much as good 1 originally.

x2

x2 x2

x1

x1

x1

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The Slutsky identity

The total change in demand, x , is the change in demand due to the change in price holding income constant: x1 x1 ( p1' , y) x1 ( p1 y) This change is broken down into the substitution and income effects:

x1 x1s x1n x1 ( p1' , y) x1 ( p1 , y) [ x1 ( p1' , y ' ) x1 ( p1 , y)] [ x1 ( p1' , y) x1 ( p1' , y ' )]

This is the Slutsky identity

The effect of a change in price can be positive or negative.

The substitution effect is always negative, the income effect can go either way. For normal goods, the income and substitution effects go in the same direction so that the effects reinforce each other. For inferior goods, it may happen that the income effect outweighs the substitution effect so that the total change in demand associated with a price increase is positive. This is the perverse Giffen good result. A Giffen good must be an inferior good but an inferior good need not necessarily be a Giffen good. For a Giffen good, the income effect is of the the opposite sign and has to be large enough to outweigh the substitution effect.

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Most goods are normal (i.e. demand increases with income). The substitution and income effects reinforce each other when a normal goods own price changes.

x2

Good 1 is normal because higher income increases demand

x2 x2

(x1,x2)

x1

x1

x1

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x2

x2 x2

Good 1 is normal because higher income increases demand, so the income and substitution effects reinforce each other. (x1,x2)

x1

x1

x1

Since both the substitution and income effects increase demand when own-price falls, a normal goods ordinary demand curve slopes down. The Law of Downward-Sloping Demand therefore always applies to normal goods.

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Some goods are income-inferior (i.e. demand is reduced by higher income). The substitution and income effects oppose each other when an income-inferior goods own price changes.

x2

x2

x1

x1

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x2

x2

x1

x1

x2

x2

x1

x1

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x2

x2 x2

x1

x1

x1

x2

The pure substitution effect is as for a normal good. But, .

x2 x2

x1

x1

x1

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x2

The pure substitution effect is as for a normal good. But, the income effect is in the opposite direction. (x1,x2)

x2 x2

x1

x1

x1

x2

x2 x2

The pure substitution effect is as for a normal good. But, the income effect is in the opposite direction. Good 1 is income-inferior because an (x1,x2) increase to income causes demand to fall.

x1

x1

x1

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x2

The overall changes to demand are the sums of the substitution and income effects. (x1,x2)

x2 x2

x1

x1

x1

In rare cases of extreme income-inferiority, the income effect may be larger in size than the substitution effect, causing quantity demanded to fall as own-price rises. Such goods are Giffen goods.

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x2

A decrease in p1 causes quantity demanded of good 1 to fall.

x2

x1

x1

x2

A decrease in p1 causes quantity demanded of good 1 to fall.

x2

x2

x1

x1

x1

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x2

A decrease in p1 causes quantity demanded of good 1 to fall.

x2

x2

x2 x1 x1 x1 Substitution effect Income effect

x1

Slutskys decomposition of the effect of a price change into a pure substitution effect and an income effect thus explains why the Law of Downward-Sloping Demand is violated for extremely income-inferior goods.

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Expressing the identity in terms of rates of change

Define the negative of the income effect as:
x1m x1 ( p1' , y ' ) x1 ( p1' , y) x1n

The Slutsky identity then becomes:

x1 x1s x1m

Dividing by p1 , results in:

x1 x1s x1m p1 p1 p1

The first term on the RHS is the rate of change in demand when prices changes and income is adjusted to keep the old bundle affordable. Working on the second term, recall that:
y x1p1 , therefore : p1 y x1

Substituting into the last term results in:

x1 x1s x1m x1 p1 p1 y

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Interpretation of the terms:

The substitution effect: the rate of change in demand as price changes, adjusting income in order to keep the old bundle affordable:
' x1s x ( p ' , y ' ) x1 ( p1 , y) 1 1 p1 p1

The income effect: rate of change in demand holding prices fixed and letting income change:
x1m x ( p ' , y ' ) x ( p ' , y) x1 1 1 ' 1 1 x1 y y y

Income effect is composed of two pieces, how demand changes as income changes times the original level of demand

If the demand for a good increases when income increases, then the demand for that good must decrease when its price increases.

This follows directly from the Slutsky equation. If the demand increases when income increases, we have a normal good. If we have a normal good, then the substitution effects and the income effect reinforce each other, and an increase in price will unambiguously reduce demand.

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Perfect complements: Substitution effect is zero. The change in demand is due entirely to the income effect Perfect substitutes: Entire change in demand is due to the substitution effect. There is no shifting left to do. Quasilinear preferences: Entire change in demand is due to the substitution effect, the income effect is zero.

x2

Old budget line

New budget line

x1
Total effect = income effect

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Original budget line

Final budget line

Total effect = Substitution Effect

x2

x1
Total effect = substitution effect

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The Hicksian substitution effect Keeps utility constant instead of keeping purchasing power constant. Instead of pivoting the budget line, we roll the budget line around the indifference curve through the original consumption bundle such that the consumer has a budget line with the same relative prices as the new one but with a different income. The purchasing power that he has in this instance will be sufficient to purchase a bundle that is just indifferent to his original bundle. Hicks substitution effect gives the consumer just enough money to get back to his old indifference curve. Hicks substitution effect is also negative just like the Slutsky substitution effect.

x2 Original budget Final budget

x2

x1 Substitution effect Income effect

x1

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Total change in demand is still equivalent to the income plus substitution effect, except that it is the Hicks substitution effect that is considered. It can be shown that for small changes in prices, the two substitution effects are identical.

We have analyzed how quantity demanded changes as price changes in three different situations:

We can draw the relationship between price and quantity holding any of these three variables fixed, giving rise to three demand curves: the standard or ordinary, Slutsky and Hicksian demand curve. Slutsky and Hicksian demand curves are always downward sloping. The ordinary demand curve is always downward sloping for normal goods Hicksian demand curve is also called the compensated demand curve. This is since the consumers income is adjusted as price changes to keep him with the same level of utility, i.e., the consumer is not made worse off or better off.

Holding income fixed (the standard case) Holding purchasing power fixed ( the slutsky substitution effect) Holding utility fixed (Hicks substitution effect)

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