Price Change: Income and Substitution Effects

THE IMPACT OF A PRICE CHANGE

Economists

often separate the impact of a price change into two components: the substitution effect; and the income effect.

THE IMPACT OF A PRICE CHANGE

The

substitution effect involves the substitution of good x1 for good x2 or viceversa due to a change in relative prices of the two goods. The income effect results from an increase or decrease in the consumers real income or purchasing power as a result of the price change. The sum of these two effects is called the price effect.

THE IMPACT OF A PRICE CHANGE

The decomposition of the price effect into the income and substitution effect can be done in several wa s There are two main methods: !i" The #ic$sian method; and !ii" The %luts$ method

THE HICKSIAN METHOD

%ir &ohn '.#ic$s !1()*-1(+(" ,warded the -obel .aureate in Economics !with /enneth &. ,rrrow" in 1(02 for wor$ on general e1uilibrium theor and welfare economics.

THE HICKSIAN METHOD

22
4ptimal bundle is Ea5 on indifference curve 31.

Ea 31 xa

21

THE HICKSIAN METHOD

22
6 , fall in the price of 21

7
Ea

The budget line pivots out from 6

31 xa

21

THE HICKSIAN METHOD

22
The new optimum is Eb on 32. The Total 6rice Effect is xa to xb Ea xa Eb 31 xb 32

21

THE HICKSIAN METHOD

To isolate the substitution effect we as$8. 9what would the consumers optimal bundle be if s:he faced the new lower price for 21 but experienced no change in real income;< This amounts to returning the consumer to the original indifference curve !31"

THE HICKSIAN METHOD

22
The new optimum is Eb on 32. The Total 6rice Effect is xa to xb Ea xa Eb 31 xb 32

21

THE HICKSIAN METHOD

22
=raw a line parallel to the new budget line and tangent to the old indifference curve Eb 31 xa xb

Ea

32

21

THE HICKSIAN METHOD

22
The new optimum on 31 is at Ec. The movement from Ea to Ec !the increase in 1uantit demanded from 2a to 2c" is solel in response to a change in Eb relative prices 32

Ea

Ec 31

xa xc

xb

21

THE HICKSIAN METHOD

22
This is the substitution effect.

Ea

Eb Ec 31

32

2a

%ubstitution Effect

2c

21

THE HICKSIAN METHOD

To isolate the income effect 8 .oo$ at the remainder of the total price effect This is due to a change in real income.

THE HICKSIAN METHOD

22
The remainder of the total effect is due to a change in real income. The increase in real income is evidenced b the movement from 31 to 32 32

Ea

Eb Ec

31

2c

21
3ncome Effect

2b

THE HICKSIAN METHOD

22

Ea

Eb Ec xb 31

32

xa xc

21

%ub 3ncome Effect Effect

HICKSIAN ANALYSIS and DEMAND CURVES

6
M 1 = p1 x1 + p2 x 2

, fall in price from p1 to p17

,?
6 61 617

>
M 1 = p1 x1 + p2 x2

, ? >

21 Aarshallian =emand ?urve !, @ >" #ic$sian =emand ?urve !, @ ?" 21

HICKSIAN ANALYSIS and DEMAND CURVES

#ic$sian !compensated" demand curves cannot be upward-sloping !i.e. substitution effect cannot be positive"

THE SLUTSKY METHOD

Eugene %luts$ !1++)-1(*+" 'ussian economist expelled from the Bniversit of /iev for participating in student revolts. 3n his 1(1C paper5 94n the theor of the >udget of the ?onsumer< he introduced 9%luts$ =ecomposition<.

THE SLUTSKY METHOD

22
4ptimal bundle is Ea5 on indifference curve 31.

Ea 31 xa

21

THE SLUTSKY METHOD

22
6 , fall in the price of 21

7
Ea 31 xa

The budget line pivots out from 6

21

THE SLUTSKY METHOD

22
The new optimum is Eb on 32. The Total 6rice Effect is xa to xb Ea xa Eb 31 xb 32

21

THE SLUTSKY METHOD

%luts$ claimed that if5 at the new prices5 less income is needed to bu the original bundle then 9real income< has increased more income is needed to bu the original bundle then 9real income< has decreased %luts$ isolated the change in demand due onl to the change in relative prices b as$ing 9Dhat is the change in demand when the consumers income is adEusted so that5 at the new prices5 s:he can Eust afford to bu the original bundle;<

THE SLUTSKY METHOD

To isolate the substitution effect we adEust the consumers mone income so that s:he change can Eust afford the original consumption bundle. 3n other words we are holding purchasing power constant.

THE SLUTSKY METHOD

22
The new optimum is Eb on 32. The Total 6rice Effect is xa to xb Ea xa Eb 31 xb 32

21

THE SLUTSKY METHOD

22
=raw a line parallel to the new budget line which passes through the point Ea. Ea xa 31 Eb 32

xb

21

THE SLUTSKY METHOD

22
The new optimum on 3F is at Ec. The movement from Ea to Ec is the substitution effect Ea Ec xa xc xb Eb 3F 32

21

THE SLUTSKY METHOD

22
The new optimum on 3F is at Ec. The movement from Ea to Ec is the substitution effect Ea Ec xa xc Eb 3F 32

21

%ubstitution Effect

THE SLUTSKY METHOD

22
The remainder of the total price effect is the 3ncome Effect. The movement from Ec to Eb. Ea Ec xc Eb 3F xb 32

21

3ncome Effect

THE SLUTSKY METHOD for NORMAL GOODS

Aost goods are normal !i.e. demand increases with income". The substitution and income effects reinforce each other when a normal goods own price changes.

THE SLUTSKY METHOD for NORMAL GOODS

22

The income and substitution effects reinforce each other.

Ea Ec xa xc

Eb 3F

32

xb

21

THE SLUTSKY METHOD for NORMAL GOODS

%ince both the substitution and income effects increase demand when own-price falls5 a normal goods ordinar demand curve slopes downwards. The 9.aw< of =ownward-%loping =emand therefore alwa s applies to normal goods.

THE SLUTSKY EQUATION

.et

M 1 = p1 x1 + p2 x 2

be the original budget constraint and let

M 2 = p1 x1 + p2 x 2

represent the budget constraint after the %luts$ compensating variation in income has been carried out.

THE SLUTSKY EQUATION

22
A2 G A1 =emand for x1 is

x1 = x ( p1 , p2 , M )
d

Ea xa
M 2 = p1 x1 + p2 x2

M 1 = p1 x1 + p2 x2

21

THE SLUTSK E!U"TI#$

A 2 - A1

& = M 2 M 1 = & = M 2 M 1 = & = M 2 M 1 = M = x1p1 as

p1 x1

+ p2 x 2 % ( p1 x1 + p2 x 2 )

p1 x1 p1 x1

+ p2 x 2 % p1 x1 p2 x 2 % p1 x1 % p1 = p1

& = M 2 M 1 = x1 p1 % p1

gives the change in mone income needed to consume the original bundle of goods !at E,"

p1

AHx1 p1

THE SLUTSKY EQUATION

The demand curve holding A constant is given b

x1 = x

p1 ,

p2 , M 1 x

( p1 , p2 , M 1 )

!1"

which is the change in demand for x1 due to the change in its own price5 holding A and the price of x2 constant

THE SLUTSKY EQUATION

The income effect is given b
x m = x d p1 , p2 , M 1 x d p1 , p2 , M 2

!2"

The change in demand due to the %luts$ substitution effect is given b

x s = x d p1 , p2 , M 2 x d ( p1 , p2 , M 1 )

!F"

THE SLUTSKY EQUATION

Iiven

x1 = x
x m x s
?laim

( p ,M ) x ( p , p ,M ) = x (p , p ,M ) x (p , p ,M ) = x (p , p ,M ) x ( p , p ,M )
d p1 ,
1

1
1

!1" !2" !F"

x1 = x s + x m

!*"

%how this b substituting e1uations !1"5 !2" and !F" into e1uation !*"

THE SLUTSKY EQUATION

x1 = x s + x m
=ivide across b p1

x1 x s xm = + p1 p1 p1
'ecall so

M = x1p1

p1 = () M x1

THE SLUTSKY EQUATION

%ubstituting

p1 = ()M x1
x1 xs xm = + p1 p1 p1
Iives

x1 x s x m = x1 p1 p1 M

T#E %.BT%/J EKB,T34-

THE SLUTSKY METHOD INFERIOR GOODS

%ome

goods are !sometimes" inferior !i.e. demand is reduced b higher income". The substitution and income effects 9oppose< each other when an inferior goods own price changes.

THE SLUTSKY METHOD INFERIOR GOODS

22

Eb Ea Ec xa xa to xc xb xc 3F

32

The substitution effect is as per usual. >ut5 the income effect is in the opposite direction.

21
xc to xb

GIFFEN GOODS

3n rare cases of extreme inferiorit 5 the income effect ma be larger in siLe than the substitution effect5 causing 1uantit demanded to rise as own price falls. %uch goods are Iiffen goods. Iiffen goods are ver inferior goods.

THE SLUTSKY METHOD for INFERIOR GOODS

22
Eb Ea Ec xa to xc xb xa xc 3F 32

3n rare cases of extreme incomeinferiorit 5 the income effect ma be larger in siLe than the substitution effect5 causing 1uantit demanded to fall as own-price falls.

21
xc to xb

SLUTSKY!S EFFECT FOR GIFFEN GOODS

%luts$ s decomposition of the effect of a price change into a pure substitution effect and an income effect thus explains wh the 9.aw< of =ownward-%loping =emand is violated for ver inferior goods.

'EC#&P#SITI#$ of T#T"L P(ICE E))ECT:

PE()ECT C#&PLE&E$TS 22 31 , fall in the price of 21 32

-o substitution effect
-ew >udget ?onstraint

>
4riginal >udget ?onstraint

,H?

21

'EC#&P#SITI#$ of T#T"L P(ICE E))ECT

PE()ECT SU*STITUTES +