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
h substitution
b i i effect;
ff
and
d
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
ff
results from
f
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 ways
There
Th
are two main
i methods:
h d
(i) The Hicksian method; and
(ii) The Slutsky method

THE HICKSIAN METHOD

Sir John R.Hicks (1904-1989)
(1904 1989)
Awarded the Nobel Laureate in
E
Economics
i (with
( ith Kenneth
K
th J.
J Arrrow)
A
)
in 1972 for work on general
equilibrium theory and welfare
economics.

THE HICKSIAN METHOD

Optimal bundle is Ea, on
indifference curve I1.

X2

Ea
I1
xa

X1

THE HICKSIAN METHOD

A ffall
ll in
i the
th price
i off X1

X2

The budget
g line pivots
p
out from P

Ea
I1
xa

X1

THE HICKSIAN METHOD

The new optimum is
Eb on I2.

X2

The Total Price

Effect is xa to xb
Ea

Eb

I2

I1
xa

xb

X1

THE HICKSIAN METHOD

To isolate the substitution effect we ask.

what would the consumer
consumers
s optimal
what
bundle be if s/he faced the new lower price
for X1 but experienced no change in real
income?
This amounts to returning the consumer
to the original indifference curve (I1)

THE HICKSIAN METHOD

The new optimum is
Eb on I2.

X2

The Total Price

Effect is xa to xb
Ea

Eb

I2

I1
xa

xb

X1

THE HICKSIAN METHOD

Draw a line parallel to
the new budget line and
tangent to the old
indifference curve

X2

Ea

Eb

I2

I1
xa

xb

X1

THE HICKSIAN METHOD

The new optimum on I1 is
at Ec. The movement from
Ea to Ec (the increase in
quantity demanded from
Xa to Xc) is solely in
response to a change in
Eb
relative prices
I2

X2

Ea

Ec I1
xa xc

xb

X1

THE HICKSIAN METHOD

This is
Thi
i the
th
substitution effect.

X2

Eb

Ea

I2

Ec
I1

Xa

Substitution
S
b tit ti
Effect

Xc

X1

THE HICKSIAN METHOD

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

THE HICKSIAN METHOD

The remainder of the total
effect is due to a change
in real income. The
increase in real income is
evidenced by
y the
movement from I1 to I2
Eb
I2

X2

Ea
Ec

I1

Xc

X1
Income Effect
ff

Xb

THE HICKSIAN METHOD

X2

Eb

Ea

I2

Ec
I1
xa xc

xb

Sub
S
b Income
I
Effect Effect

X1

HICKSIAN ANALYSIS and DEMAND CURVES

P

A fall in price
from p1 to p1*

M1 p1 x1 p2 x2

AC
P
P1
P1*

B
M1 p1 x1 p2 x2

X1
Marshallian Demand
Curve (A & B)

A
B
C

Hicksian Demand
Curve (A & C)
X1

HICKSIAN ANALYSIS and DEMAND

CURVES

Hicksian (compensated) demand

curves cannot be upward
upward-sloping
sloping
(i.e. substitution effect cannot be
positive)

THE SLUTSKY METHOD

Eugene Slutsky (1880-1948)
Russian economist expelled from the
University of Kiev for participating in
student revolts.
In his 1915 paper, On the theory of
the Budget of the Consumer
Consumer he
introduced Slutsky Decomposition.

THE SLUTSKY METHOD

Optimal bundle is Ea, on
indifference curve I1.

X2

Ea
I1
xa

X1

THE SLUTSKY METHOD

A ffall
ll in
i the
th price
i off X1

X2

The budget
g line pivots
p
out from P

Ea
I1
xa

X1

THE SLUTSKY METHOD

The new optimum is
Eb on I2.

X2

The Total Price

Effect is xa to xb
Ea
xa

Eb
I1
xb

I2

X1

THE SLUTSKY METHOD

Slutsky claimed that if, at the new prices,

less income is needed to buy the original
bundle then real income has increased
more income is needed to buy the
original bundle then real income has
decreased
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,
th t att the
th new prices,
i
s/he
/h can just
j t
afford to buy the original bundle?

THE SLUTSKY METHOD

To isolate the substitution effect we
adjust the consumers
consumer s money
income so that s/he change can just
afford the original consumption
bundle.
In other words we are holding
purchasing power constant.

THE SLUTSKY METHOD

The new optimum is
Eb on I2.

X2

The Total Price

Effect is xa to xb
Ea
xa

Eb
I1
xb

I2

X1

THE SLUTSKY METHOD

Draw a line parallel
to the new budget
line which passes
through the point
Ea
Ea.

X2

Eb

Ea

I2

I1
xa

xb

X1

THE SLUTSKY METHOD

The new optimum
on I3 is
i att Ec.
E The
Th
movement from Ea
t E
to
Ec iis the
th
substitution effect

X2

Eb

Ea
Ec
xa

xc xb

I2

I3

X1

THE SLUTSKY METHOD

The new optimum
on I3 is
i att Ec.
E The
Th
movement from Ea
t E
to
Ec iis the
th
substitution effect

X2

Eb

Ea
Ec
xa

I2

I3

xc

Substitution Effect

X1

THE SLUTSKY METHOD

The remainder of
th total
the
t t l price
i effect
ff t
is the Income Effect.

X2

The movement from

Ec to Eb.
Eb

Ea
Ec
xc

I2

I3
xb

Income Effect

X1

THE SLUTSKY METHOD for NORMAL

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

THE SLUTSKY METHOD for

NORMAL GOODS
The income and
substitution
b tit ti effects
ff t
reinforce each
other.
th

X2

Eb

Ea
Ec
xa

xc

I2

I3
xb

X1

THE SLUTSKY METHOD for NORMAL

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

THE SLUTSKY EQUATION

Q
Let

M 1 p1 x 1 p 2 x 2

be the original budget constraint

and let
M

p 1 x 1 p 2 x 2

represent the budget constraint after the

Slutsky compensating variation in income
has been carried out.

THE S
SLUTSKY
U S
EQUATION
QU
ON
X2

M2 < M1

Demand for x1 is

x1 x p1, p2 , M
d

M1 p1 x1 p2 x2
Ea
xa
M2 p1x1 p2 x2

X1

THE SLUTSKY EQUATION

M2 - M1

M M 2 M 1

M M 2 M 1

p1 x1

p2 x2 - p1 x1 p2 x2

M M 2 M 1

p1 x1

- p1 x1

M M 2 M 1

x1 p1

M x1p1 as

p1 x1

p1

p2 x2 - p1 x1 p2 x2

- p1

- p1 p1

gives
i
the
th change
h
in
i money
income needed to
consume the original
bundle of goods (at EA)

M=x1p
p1

THE S
SLUTSKY
U S
EQUATION
QU
ON
The demand curve holding
gM
constant is given by

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 price, holding M and
the price of x2 constant

THE SLUTSKY EQUATION

Q
The income effect is given by

x m x d p1 , p2 , M 1 x d p1 , p2 , M 2

(2)

The change in demand due to the Slutsky

substitution effect is given by

x s x d p1 , p2 , M 2 x d p1 , p2 , M 1

(3)

THE SLUTSKY EQUATION

Given

p , M x p , p , M
x p , p , M x p , p , M
x p , p , M x p , p , M

x1 x

x m

x s

p1 ,

(1)

(2)

(3)

Claim

x1 x s x m

(4)

Show this by substituting equations (1), (2)

and (3) into equation (4)

THE SLUTSKY EQUATION

Q
x1 x s x m
Divide across by p1

x1 x s x m

p1 p1 p1
Recall
so

M x1p1

p1 () M x1

THE SLUTSKY EQUATION

Q
Substituting

p1 ()M x1
x1 xs xm

p1 p1 p1
Gives

x1 x s x m

x1
p1 p1 M

THE
SLUTSKY
EQUATION

THE SLUTSKY METHOD: INFERIOR

GOODS
Some goods are (sometimes) inferior
(i e demand is reduced by higher
(i.e.
income).
The
Th substitution
b i i and
d income
i
effects
ff
oppose each other when an
inferior goods own price changes.

THE SLUTSKY METHOD: INFERIOR

GOODS
X2

Eb

I2

The substitution
effect
ff t iis as per
usual. But, the
i
income
effect
ff t is
i
in the opposite
di
direction.
ti

Ea
Ec
xa

I3

xb xc

X1

xa to xc
xc to xb

GIFFEN GOODS
In rare cases of extreme inferiority,
the income effect may be larger in
size than the substitution effect,
causing quantity demanded to rise
as own price falls.
Such goods are Giffen goods.
Giffen goods are very inferior goods.
goods

THE SLUTSKY METHOD for

INFERIOR GOODS
In rare cases of
extreme
t
iincomeinferiority, the income
effect may be larger
in size than the
substitution effect,
effect
causing quantity
demanded
de
a ded to fall
a as
own-price falls.

X2
Eb

I2

Ea
Ec
xa to xc

xb xa

I3

xc

X1
xc to xb

SLUTSKYS EFFECT FOR

GIFFEN GOODS

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 very inferior goods.

DECOMPOSITION of TOTAL PRICE EFFECT:

PERFECT COMPLEMENTS
X2

A fall in the price of X1

I1

I2

B
Original
Budget
Constraint

No substitution
effect
New
Budget
Constraint

A=C

X1

DECOMPOSITION of TOTAL PRICE EFFECT

PERFECT SUBSTITUTES
?