1. INCOME AND SUBSTITUTION EFFECTS
Chapter 5
INCOME AND SUBSTITUTION EFFECTS

2. Objectives
How will changes in prices and income influence influence consumer’s optimal choices?
We will look at partial derivatives

3. Demand Functions (review)
We have already seen how to obtain consumer’s optimal choice
Consumer’s optimal choice was computed Max consumer’s utility subject to the budget constraint
After solving this problem, we obtained that optimal choices depend on prices of all goods and income.
We usually call the formula for the optimal choice: the demand function
For example, in the case of the Complements utility function, we obtained that the demand function (optimal choice) is:

4. Demand Functions
If we work with a generic utility function (we do not know its mathematical formula), then we express the demand function as:
x* = x(px,py,I)
y* = y(px,py,I)
We will keep assuming that prices and income is exogenous, that is:
the individual has no control over these parameters

5. Simple property of demand functions
If we were to double all prices and income, the optimal quantities demanded will not change
Notice that the budget constraint does not change (the slope does not change, the crossing with the axis do not change either)
xi* = di(px,py,I) = di(2px,2py,2I)

6. Changes in Income
Since px/py does not change, the MRS will stay constant
An increase in income will cause the budget constraint out in a parallel fashion (MRS stays constant)

7. What is a Normal Good?
A good xi for which xi/I  0 over some range of income is a normal good in that range

8. Normal goods
If both x and y increase as income rises, x and y are normal goods
Quantity of y
As income rises, the individual chooses
to consume more x and y C U3 B U2 A U1
Quantity of x

9. What is an inferior Good?
A good xi for which xi/I < 0 over some range of income is an inferior good in that range

10. Inferior good If x decreases as income rises, x is an inferior good
As income rises, the individual chooses
to consume less x and more y
Quantity of y C U3 B U2 A U1
Quantity of x

11. Changes in a Good’s Price
A change in the price of a good alters the slope of the budget constraint (px/py)
Consequently, it changes the MRS at the consumer’s utility-maximizing choices
When a price changes, we can decompose consumer’s reaction in two effects:
substitution effect
income effect

12. Substitution and Income effects
Even if the individual remained on the same indifference curve when the price changes, his optimal choice will change because the MRS must equal the new price ratio
the substitution effect
The price change alters the individual’s real income and therefore he must move to a new indifference curve
the income effect

13. Sign of substitution effect (SE)
SE is always negative, that is, if price increases, the substitution effect makes quantity to decrease and conversely. See why:
1) Assume px decreases, so: px1< px0
2) MRS(x0,y0)= px0/ py0 & MRS(x1,y1)= px1/ py0
1 and 2 implies that:
MRS(x1,y1)<MRS(x0,y0)
As the MRS is decreasing in x, this means that x has increased, that is: x1>x0

14. Changes in the optimal choice when a price decreasesU1 A
Suppose the consumer is maximizing
utility at point A.
Quantity of y U2 B
If the price of good x falls, the consumer
will maximize utility at point B.
Total increase in x
Quantity of x

15. Substitution effect when a price decreases
To isolate the substitution effect, we hold
utility constant but allow the
relative price of good x to change.
Purple is parallel to the new one
Quantity of y C
The substitution effect is the movement
from point A to point C
The individual substitutes
good x for good y
because it is now
relatively cheaper A
Substitution effect U1
Quantity of x

16. Income effect when the price decreases
The income effect occurs because the
individual’s “real” income changes
(hence utility changes) when
the price of good x changes
Quantity of y B
The income effect is the movement
from point C to point B
If x is a normal good,
the individual will buy
more because “real”
income increased
Income effect A C U2 U1
Quantity of x
How would the graph change if the good was inferior?

17. Subs and income effects when a price increases
Quantity of y
An increase in the price of good x means that
the budget constraint gets steeper C
The substitution effect is the
movement from point A to point C
Substitution effect A
Income effect
The income effect is the
movement from point C
to point B B U1 U2
Quantity of x
How would the graph change if the good was inferior?

18. Price Changes for Normal Goods
If a good is normal, substitution and income effects reinforce one another
when price falls, both effects lead to a rise in quantity demanded
when price rises, both effects lead to a drop in quantity demanded

19. Price Changes for Inferior Goods
If a good is inferior, substitution and income effects move in opposite directions
The combined effect is indeterminate
when price rises, the substitution effect leads to a drop in quantity demanded, but the income effect is opposite
when price falls, the substitution effect leads to a rise in quantity demanded, but the income effect is opposite

20. Giffen’s Paradox
If the income effect of a price change is strong enough, there could be a positive relationship between price and quantity demanded
an increase in price leads to a drop in real income
since the good is inferior, a drop in income causes quantity demanded to rise

21. A Summary
Utility maximization implies that (for normal goods) a fall in price leads to an increase in quantity demanded
the substitution effect causes more to be purchased as the individual moves along an indifference curve
the income effect causes more to be purchased because the resulting rise in purchasing power allows the individual to move to a higher indifference curve
Obvious relation hold for a rise in price…

22. A Summary
Utility maximization implies that (for inferior goods) no definite prediction can be made for changes in price
the substitution effect and income effect move in opposite directions
if the income effect outweighs the substitution effect, we have a case of Giffen’s paradox

23. Compensated Demand Functions
This is a new concept
It is the solution to the following problem:
MIN PXX+ PYY
SUBJECT TO U(X,Y)=U0
Basically, the compensated demand functions are the solution to the Expenditure Minimization problem that we saw in the previous chapter
After solving this problem, we obtained that optimal choices depend on prices of all goods and utility. We usually call the formula: the compensated demand function
x* = xc(px,py,U),
y* = yc(px,py,U)

24. Compensated Demand Functions
xc(px,py,U0), and yc(px,py,U0) tell us what quantities of x and y minimize the expenditure required to achieve utility level U0 at current prices px,py
Notice that the following relation must hold:
pxxc(px,py,U0)+ pyyc(px,py,U0)=E(px,py,U0)
So this is another way of computing the expenditure function !!!!

25. Compensated Demand Functions
There are two mathematical tricks to obtain the compensated demand function without the need to solve the problem:
MIN PXX+ PYY
SUBJECT TO U(X,Y)=U0
One trick(A) (called Shephard’s Lemma) is using the derivative of the expenditure function
Another trick(B) is to use the marshallian demand and the expenditure function

26. Compensated Demand Functions
Sheppard’s Lema to obtain the compensated demand function
Intuition: a £1 increase in px raises necessary expenditures by x pounds, because £1 must be paid for each unit of x purchased.
Proof: footnote 5 in page 137

27. Trick (B) to obtain compensated demand functions

28. Trick (B) to obtain compensated demand functions
Suppose that utility is given by
utility = U(x,y) = x0.5y0.5
The Marshallian demand functions are
x = I/2px y = I/2py
The expenditure function is

29. Another trick to obtain compensated demand functions
Substitute the expenditure function into the Marshallian demand functions, and find the compensated ones:

30. Compensated Demand Functions
Demand now depends on utility (V) rather than income
Increases in px changes the amount of x demanded, keeping utility V constant. Hence the compensated demand function only includes the substitution effect but not the income effect

31. Roy’s identity
It is the relation between marshallian demand function and indirect utility function
Proof of the Roy’s identity…

32. Proof of Roy’s identity

33. Demand curves…
We will start to talk about demand curves. Notice that they are not the same that demand functions !!!!

34. The Marshallian Demand Curve
An individual’s demand for x depends on preferences, all prices, and income:
x* = x(px,py,I)
It may be convenient to graph the individual’s demand for x assuming that income and the price of y (py) are held constant

35. The Marshallian Demand Curve
Quantity of y
As the price
of x falls... px x’
px’ U1 x1
I = px’ + py
x’’
px’’ U2 x2
I = px’’ + py
x’’’
px’’’ x3 U3
I = px’’’ + py x
…quantity of x
demanded rises.
Quantity of x
Quantity of x

36. The Marshallian Demand Curve
The Marshallian demand curve shows the relationship between the price of a good and the quantity of that good purchased by an individual assuming that all other determinants of demand are held constant
Notice that demand curve and demand function is not the same thing!!!

37. Shifts in the Demand Curve
Three factors are held constant when a demand curve is derived
income
prices of other goods (py)
the individual’s preferences
If any of these factors change, the demand curve will shift to a new position

38. Shifts in the Demand Curve
A movement along a given demand curve is caused by a change in the price of the good
a change in quantity demanded
A shift in the demand curve is caused by changes in income, prices of other goods, or preferences
a change in demand

39. Compensated Demand Curves
An alternative approach holds utility constant while examining reactions to changes in px
the effects of the price change are “compensated” with income so as to constrain the individual to remain on the same indifference curve
reactions to price changes include only substitution effects (utility is kept constant)

40. Marshallian Demand Curves
The actual level of utility varies along the demand curve
As the price of x falls, the individual moves to higher indifference curves
it is assumed that nominal income is held constant as the demand curve is derived
this means that “real” income rises as the price of x falls

41. Compensated Demand Curves
A compensated (Hicksian) demand curve shows the relationship between the price of a good and the quantity purchased assuming that other prices and utility are held constant
The compensated demand curve is a two-dimensional representation of the compensated demand function
x* = xc(px,py,U)

42. Compensated Demand Curves
Holding utility constant, as price falls...
Quantity of y px x’
px’ xc
…quantity demanded
rises. U2
x’’
px’’
x’’’
px’’’
Quantity of x
Quantity of x

43. Compensated & Uncompensated Demand for normal goodspx
x’’
px’’
At px’’, the curves intersect because
the individual’s income is just sufficient to attain utility level U2 x xc
Quantity of x

44. Compensated & Uncompensated Demand for normal goodsx* x’
px’
At prices above p’’x, income compensation is positive because the individual needs some help to remain on U2 px
px’’ x xc
Quantity of x
As we are looking at normal goods, income and substitution effects go in the same direction, so they are reinforced. X includes both while Xc only the substitution effect. That is what drives the relative position of both curves

45. Compensated & Uncompensated Demand for normal goodspx
x***
x’’’
px’’’
At prices below px2, income compensation is negative to prevent an increase in utility from a lower price
px’’ x xc
As we are looking at normal goods, income and substitution effects go in the same direction, so they are reinforced. X includes both while Xc only the substitution effect. That is what drives the relative position of both curves
Quantity of x

46. Compensated & Uncompensated Demand
For a normal good, the compensated demand curve is less responsive to price changes than is the uncompensated demand curve
the uncompensated demand curve reflects both income and substitution effects
the compensated demand curve reflects only substitution effects

47. Relations to keep in mind
Sheppard’s Lema & Roy’s identity
V(px,py,E(px,py,Uo)) = U0
E(px,py,V(px,py,I0)) = I0
xc(px,py,U0)=x(px,py,I0)

48. A Mathematical Examination of a Change in Price
Our goal is to examine how purchases of good x change when px changes
x/px
Differentiation of the first-order conditions from utility maximization can be performed to solve for this derivative

49. A Mathematical Examination of a Change in Price
However, for our purpose, we will use an indirect approach
Remember the expenditure function
minimum expenditure = E(px,py,U)
Then, by definition
xc (px,py,U) = x [px,py,E(px,py,U)]
quantity demanded is equal for both demand functions when income is exactly what is needed to attain the required utility level

50. A Mathematical Examination of a Change in Price
xc (px,py,U) = x[px,py,E(px,py,U)]
We can differentiate the compensated demand function and get

51. A Mathematical Examination of a Change in Price
The first term is the slope of the compensated demand curve
the mathematical representation of the substitution effect

52. A Mathematical Examination of a Change in Price
The second term measures the way in which changes in px affect the demand for x through changes in purchasing power
the mathematical representation of the income effect

53. The Slutsky Equation
The substitution effect can be written as
The income effect can be written as

54. The Slutsky Equation
A price change can be represented by

55. The Slutsky Equation The first term is the substitution effect
always negative as long as MRS is diminishing
the slope of the compensated demand curve must be negative

56. The Slutsky Equation The second term is the income effect
if x is a normal good, then x/I > 0
the entire income effect is negative
if x is an inferior good, then x/I < 0
the entire income effect is positive

57. A Slutsky Decomposition
We can demonstrate the decomposition of a price effect using the Cobb-Douglas example studied earlier
The Marshallian demand function for good x was

58. A Slutsky Decomposition
The Hicksian (compensated) demand function for good x was
The overall effect of a price change on the demand for x is

59. A Slutsky Decomposition
This total effect is the sum of the two effects that Slutsky identified
The substitution effect is found by differentiating the compensated demand function

60. A Slutsky Decomposition
We can substitute in for the indirect utility function (V)

61. A Slutsky Decomposition
Calculation of the income effect is easier
By adding up substitution and income effect, we will obtain the overall effect