Substitution Effect

Adrian Monk is an OCD detective who spends all of his income on Monkey Grease, a powerful all-purpose cleaner, and hand wipes. What will happen to the amount Adrian will buy if the price of Monkey Grease increases? Adrian will buy less of the detergent. When the price is P1, Adrian purchases Q1 and receives a marginal benefit equal to point 1. If the price increases to P2, Adrian will NOT consume Q1 because the marginal cost is greater than the marginal benefit. Adrian will equal benefits with costs at point 2 and reduce is consumption from Q1 to Q2. Moving to this new equilibrium is what economics predicts. That is, a consumer will seek to maximize his pleasure and avoid pain. This point occurs at point 2 where MB = MC. In microeconomics, the questions that economists ponder change, but the answer is always where marginal benefit equals marginal cost.

Microeconomics is like a donkey because He-Haw, He-Haw, He always equates where marginal benefit equals marginal cost.

Income Effect

Adrian purchases wipes and household cleanser in equal quantities because that maximizes his utility. On his original budget constraint, Adrian buys 5 wipes and 5 bottles of Monkey Grease for a total utility of 25 Utils. All of his $10 income, Y, is spent at this point as can be seen in equation (1). If the price of Monkey Grease decreases to 50 cents, then Monk feels wealthier even though he is not. Monk would only need $7.50 to buy the same amount of cleanser as before. The amount he would buy because he feels wealthier is the income effect. Only economists could theorize that in order to add more to your income youd have to subtract.

Substitution and Income Effects in the Indifference Curve model

Homer Simpson, our representative consumer, consumes varying amounts of beer and pork rinds. Assume that B = quantity of beer consumed, and that R = quantity of pork rinds consumed. Homers utility function is given as:

The marginal rate of substitution (which is the slope of Homers indifference curve) between beer and pork rinds is given in absolute value as:

Recall that this can be derived from Homers utility function. If we use a different utility function, then we get a different MRSR,B. Assume further that the price of beer is $4, the price of pork rinds is $2, and that Homers income is $200. We can obtain Homers budget constraint from this information, which we can rearrange as:

B = -0.5R + 50.

A consumer equilibrium occurs in the graph below at pt. X1, where the (blue) indifference curve is tangent to the (red) budget constraint.

It is possible to calculate the quantities of beer and pork rinds at this consumer equilibrium. After doing so, we would find that B* = 25 units and R* = 50 units. How is the graph above affected when the price of pork rinds increases from $2 to $4? This change is shown on the graph below. The budget constraint becomes steeper and Homer moves to a new (pink) indifference curve and a lower level of utility at pt. X2. If we calculate the new consumer equilibrium at pt. X2, we would get B* = 25 and R* = 25.

Notice, however, that the price change included two actions. The movement from pt. X1 to pt. X2 involved a change in the marginal rate of substitution (i.e. a change in the slope

of the indifference curve), and a change in utility (i.e. a change from the blue indifference curve to the pink indifference curve). This is different from a change in income, which only involves one change a change in utility. These two actions form the analytical basis for what we call the substitution effect and the income effect.

The Substitution and Income Effects When prices rise, consumers lose purchasing power. What if the price of pork rinds goes up, but the government offers to compensate Homer for this loss of purchasing power. That is, Mayor Quimby offers to mail Homer a check, in an effort to keep Homer from feeling worse off. Homer still faces the higher pork rinds price, but doesnt experience a change in utility. That is, for Homer to be no worse off after the price increase, the government check must be large enough to keep Homer on his original indifference curve. If the government check allows Homer to remain on his original indifference curve, will he just return to pt. X1 and go back to buying 50 units of pork rinds? No. Even though Homer would return to his original indifference curve, he would also still face a different pair of prices. Therefore, we know that Homer must be located at a different point on that original indifference curve. By taking the second graph above, and drawing a hypothetical budget constraint, we can find this new point. This new constraint must satisfy two criteria. First, the constraint must be parallel to the new prices (where beer and pork rinds each cost $4). Second, the constraint must be tangent to the original indifference curve. The dotted line in the graph below satisfies these criteria, and so represents this new constraint. This line is tangent to Homers original indifference curve at pt. W. This point reveals the quantities of beer and pork rinds that Homer would buy after receiving his government check (the check that keeps his utility constant). Of course, in real life, Homer would never get a check from the Mayor, but we will use pt. W to distinguish between the two actions (or effects) we noted as occuring with every price change.

How much would Homer consume at pt. W? The calculation is somewhat involved. First, note that the slope of Homers new constraint is -1. Consequently, at pt. W, the slope of his original indifference curve equals -1. If R/B = 1 at pt. W, then B = R at pt. W also. That is, we can ascertain that Homer will buy an equal amount of beer and pork rinds at pt. W. Homers original level of utility is (i.e. plug the original consumer equilibrium values of B = 25 and R = 50 into Homers utility function) To maintain Homers original level of utility, then it must be true that:

That is, Homer will buy some combination of B and R that makes his utility function equal to Recall that at pt. W, Homer will buy an equal amount of beer and pork rinds. Therefore, we can rewrite Homer's original level of utility (given above) as Of course, the equation above tells us that B* is equal to we have the following: , so given that B* = R*,

The new (hypothetical) budget constraint would be given as 4B + 4R = 200 + I, where I is the change in income necessary to keep Homers utility constant. Plugging in B* and R* from the paragraph above, we find that I = $82.84. That is, if Homer receives a check for $82.84, then Homer can continue to receive his original level of utility (i.e. utils) even though pork rinds are $2 more expensive now. What are the substitution and income effects? The two effects are separated by pt. W. As the quantity of pork rinds changes between pt. W and pt. X1 we observe the substitution effect. At pt. X1, Homer consumes 50 units of pork rinds. At pt. W, Homer consumes units of pork rinds (i.e. about 35.36 units). The substitution effect associated with this price increase is represented by a decrease in quantity. That is, the substitution effect reveals a negative relationship between the price and quantity change. In fact, with every price change, we find this negative relationship within the substitution effect.

The income effect is measured as the quantity change attributed to moving from pt. W to pt. X2. Between these two points, only utility changes, there is no change in the slope of the budget constraint. At pt. X2, Homer consumes 25 units of pork rinds. The difference between pts. W and X2 is , or about 10.36 units.

Note that, like the substitution effect, there is a decrease in quantity within the income effect. Unlike the substitution effect, however, a negative relationship between price and quantity does not always arise within the income effect. For normal goods, the income effect reveals a negative relationship between price and quantity changes. That is, price increases lead to the income effect involving a decrease in quantity, and price decreases lead to the income effect involving an increase in quantity. Obviously, Homer considers pork rinds to be a normal good. For inferior goods, we get the opposite result the income effect involves a positive relationship between price and quantity changes. Any increase in price (decrease) would lead to the income effect yielding an increase in quantity (decrease). Suppose the inferior good is highly inferior. For example, suppose we have a good where any small increase in price leads to a large, positive income effect. This would explain why a fairly large price change leads to an insignificant (overall) change in quantity. The inferior goods large income effect moves in the opposite direction of the substitution effect, causing the overall change (i.e. the sum of the two effects) to be very small. In some cases, if a good is inferior enough, the positive income effect may be so large that it leads to price increases (decreases) being accompanied by overall quantity increases (decreases). When this occurs, we are dealing with a special (and rare) type of good known as a Giffen good. Giffen goods are so inferior that the income effect overwhelms the substitution effect, leading to the perverse result described above where there is an overall positive relationship between price and quantity changes.

Substitution effect
Main article: Substitute good

The substitution effect is the effect observed with changes in relative price of goods. This effect basically affects the movement along the curve. These curves can be used to predict the effect of changes to the budget constraint. The graphic below shows the effect of a price increase for good Y. If the price of Y increases, the budget constraint will pivot from BC2 to BC1. Notice that because the price of X does not change, the consumer can still buy the same amount of X if he or she chooses to buy only good X. On the other hand, if the consumer chooses to buy only good Y, he or she will be able to buy less of good Y because its price has increased.

To maximize the utility with the reduced budget constraint, BC1, the consumer will re-allocate consumption to reach the highest available indifference curve which BC1 is tangent to. As shown on the diagram below, that curve is I1, and therefore the amount of good Y bought will shift from Y2 to Y1, and the amount of good X bought to shift from X2 to X1. The opposite effect will occur if the price of Y decreases causing the shift from BC2 to BC3, and I2 to I3.

If these curves are plotted for many different prices of good Y, a demand curve for good Y can be constructed. The diagram below shows the demand curve for good Y as its price varies. Alternatively, if the price for good Y is fixed and the price for good X is varied, a demand curve for good X can be constructed.

Income effect
Main article: Income effect

Another important item that can change is the money income of the consumer. The income effect is the phenomenon observed through changes in purchasing power. It reveals the change in quantity demanded brought by a change in real income (utility). Graphically, as long as the prices remain constant, changing the income will create a parallel shift of the budget constraint. Increasing the income will shift the budget constraint right since more of both can be bought, and decreasing income will shift it left.

Depending on the indifference curves, as income increases, the amount purchased of a good can either increase, decrease or stay the same. In the diagram below, good Y is a normal good since the amount purchased increased as the budget constraint shifted from BC1 to the higher income BC2. Good X is an inferior good since the amount bought decreased as the income increases.

is the change in the demand for good 1 when we change income from the price of good 1 fixed at :

to

, holding

Price effect as sum of substitution and income effects

Further information: Slutsky equation and Hicksian demand

Every price change can be decomposed into an income effect and a substitution effect; the price effect is the sum of substitution and income effects. The substitution effect is a price change that alters the slope of the budget constraint but leaves the consumer on the same indifference curve. In other words, it illustrates the consumer's new consumption basket after the price change while being compensated as to allow the consumer to be as happy as he or she was previously. By this effect, the consumer is posited to substitute toward the good that becomes comparatively less expensive. In the illustration below this corresponds to an imaginary budget constraint denoted SC being tangent to the indifference curve I1. If the good in question is a normal good, then the income effect from the rise in purchasing power from a price fall reinforces the substitution effect. If the good is an inferior good, then the income effect will offset in some degree the substitution effect. If the income effect for an inferior good is sufficiently strong, the consumer will buy less of the good when it becomes less expensive, a Giffen good (commonly believed to be a rarity).

In the figure, the substitution effect, price of good falls from money income falls from to to

, is the change in the amount demanded for

when the

(increasing purchasing power for ) and, at the same time, the to keep the consumer at the same level of utility on :

The substitution effect increases the amount demanded of good from to . In the example, the income effect of the price fall in partly offsets the substitution effect as the amount demanded of goes from to . Thus, the price effect is the algebraic sum of the substitution effect and the income effect.

Assumptions
The behavioral assumption of consumer theory is that all consumers are rational decision makers who seek to maximize utility. More specifically, in the eyes of economists, all consumers seek to maximize a utility function subject to a budgetary constraint.[2] In other words, economists assume that consumers will always choose the "best" bundle of goods they can afford.[3] Consumer theory is therefore based around the problem of generate refutable hypotheses about the nature of consumer demand from this behavioral postulate.[2] In order to reason from the central postulate towards a useful model of consumer choice, it is necessary to make additional assumptions about the certain preferences that consumers employ when selecting their preferred "bundle" of goods. These are relatively strict, allowing for the model to generate more useful hypotheses with regard to consumer behaviour than weaker assumptions, which would allow any empirical data to be explained in terms of stupidity, ignorance, or some other factor, and hence would not be able to generate any predictions about future demand at all.[2] For the most part, however, they represent statements which would only be contradicted if a consumer was acting in (what was widely regarded as) a strange manner.[4] In this vein, the modern form of consumer choice theory assumes:
Preferences are complete Consumer choice theory is based on the assumption that the consumer fully understands his or her own preferences, allowing for a simple but accurate comparison between any two bundles of good presented.[3] That is to say, it is assumed that if a consumer is presented with two consumption bundles A and B each containing different combinations of n goods, the consumer can unambiguously decide if (s)he prefers A to B, B to A, or is indifferent to both.[2][3] The few scenarios where it is possible to imagine that decision-making would be very difficult are thus placed "outside the domain of economic analysis".[3] Preferences are reflexive Means that if A and B are in all respect identical the consumer will consider a to be at least as good as (is weakly preferred) to B.[3] Alternatively, the axiom can be modified to read that the consumer is indifferent with regard to A and B.[5] Preference are transitive If A is preferred to B and B is preferred to C then A must be preferred to C. This also means that if the consumer is indifferent between A and B and is indifferent between B and C she will be indifferent between A and C. This is the consistency assumption. This assumption eliminates the possibility of intersecting indifference curves. Preferences exhibit non-satiation

This is the "more is always better" assumption; that in general if a consumer is offered two almost identical bundles A and B, but where B includes more of one particular good, the consumer will choose B.[6] Among other things this assumption precludes circular indifference curves. Non-satiation in this sense is not a necessary but a convenient assumption. It avoids unnecessary complications in the mathematical models. Indifference Curves exhibit diminishing marginal rates of substitution This assumption assures that indifference curves are smooth and convex to the origin. This assumption is implicit in the last assumption. This assumption also set the stage for using techniques of constrained optimization. Because the shape of the curve assures that the first derivative is negative and the second is positive. The MRS tells how much y a person is willing to sacrifice to get one more unit of x. This assumption incorporates the theory of diminishing marginal utility. The primary reason to have these technical preferences is to replicate the properties of the real number system so the math will work. Goods are available in all quantities It is assumed that a consumer may choose to purchase any quantity of a good (s)he desires, for example, 2.6 eggs and 4.23 loaves of bread. Whilst this makes the model less precise, it is generally acknowledged to provide a useful simplification to the calculations involved in consumer choice theory, especially since consumer demand is often examined over a considerable period of time. The more spending rounds are offered, the better approximation the continuous, differentiable function is for its discrete counterpart. (Whilst the purchase of 2.6 eggs sounds impossible, an average consumption of 2.6 eggs per day over a month does not.)[6]

Note the assumptions do not guarantee that the demand curve will be negatively sloped. A positively sloped curve is not inconsistent with the assumptions.[7]

Use Value
In Marx's critique of political economy, any labor-product has a value and a use value, and if it is traded as a commodity in markets, it additionally has an exchange value, most often expressed as a money-price.[8] Marx acknowledges that commodities being traded also have a general utility, implied by the fact that people want them, but he argues that this by itself tells us nothing about the specific character of the economy in which they are produced and sold.

Labor-leisure tradeoff
Main article: Backward bending supply curve of labour

Consumer theory can also be used to analyze a consumer's choice between leisure and labor. Leisure is considered one good (often put on the horizontal-axis) and consumption is considered the other good. Since a consumer has a finite and scarce amount of time, he must make a choice between leisure (which earns no income for consumption) and labor (which does earn income for consumption). The previous model of consumer choice theory is applicable with only slight modifications. First, the total amount of time that an individual has to allocate is known as his time endowment, and is often denoted as T. The amount an individual allocates to labor (denoted L) and leisure (l) is constrained by T such that:

or

A person's consumption is the amount of labor they choose multiplied by the amount they are paid per hour of labor (their wage, often denoted w). Thus, the amount that a person consumes is:

When a consumer chooses no leisure

then

and

From this labor-leisure tradeoff model, the substitution and income effects of various changes in price caused by welfare benefits, labor taxation, or tax credits can be analyzed.

See also