1. INCOME AND SUBSTITUTION EFFECTS
Chapter 5
INCOME AND SUBSTITUTION EFFECTS
MICROECONOMIC THEORY
BASIC PRINCIPLES AND EXTENSIONS
EIGHTH EDITION
WALTER NICHOLSON
Copyright ©2002 by South-Western, a division of Thomson Learning. All rights reserved.

2. Demand Functions
The optimal levels of X1,X2,…,Xn can be expressed as functions of all prices and income
These can be expressed as n demand functions:
X1* = d1(P1,P2,…,Pn,I)
X2* = d2(P1,P2,…,Pn,I) •
Xn* = dn(P1,P2,…,Pn,I)

3. Xi* = di(P1,P2,…,Pn,I) = di(tP1,tP2,…,tPn,tI)
Homogeneity
If we were to double all prices and income, the optimal quantities demanded will not change
Doubling prices and income leaves the budget constraint unchanged
Xi* = di(P1,P2,…,Pn,I) = di(tP1,tP2,…,tPn,tI)
Individual demand functions are homogeneous of degree zero in all prices and income

4. Homogeneity With a Cobb-Douglas utility function
utility = U(X,Y) = X0.3Y0.7
the demand functions are
Note that a doubling of both prices and income would leave X* and Y* unaffected

5. Homogeneity With a CES utility function utility = U(X,Y) = X0.5 + Y0.5
the demand functions are
Note that a doubling of both prices and income would leave X* and Y* unaffected

6. Changes in Income
An increase in income will cause the budget constraint out in a parallel manner
Since PX/PY does not change, the MRS will stay constant as the worker moves to higher levels of satisfaction

7. Increase in Income
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

8. Increase in Income
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
Note that the indifference
curves do not have to be
“oddly” shaped. The
assumption of a diminishing
MRS is obeyed. B U2 A U1
Quantity of X

9. Normal and Inferior Goods
A good Xi for which Xi/I  0 over some range of income is a normal good in that range
A good Xi for which Xi/I < 0 over some range of income is an inferior good in that range

10. Engel’s Law
Using Belgian data from 1857, Engel found an empirical generalization about consumer behavior
The proportion of total expenditure devoted to food declines as income rises
food is a necessity whose consumption rises less rapidly than income

11. Substitution & 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

12. Changes in a Good’s Price
A change in the price of a good alters the slope of the budget constraint
it also changes the MRS at the consumer’s utility-maximizing choices
When the price changes, two effects come into play
substitution effect
income effect

13. Changes in a Good’s PriceU1 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.
Quantity of X
Total increase in X

14. Changes in a Good’s Price
Quantity of Y
To isolate the substitution effect, we hold
“real” income constant but allow the
relative price of good X to change C
Substitution effect
The substitution effect is the movement
from point A to point C B
The individual substitutes
good X for good Y
because it is now
relatively cheaper A U2 U1
Quantity of X

15. Changes in a Good’s Price
Quantity of Y
The income effect occurs because the
individual’s “real” income changes when
the price of good X changes
Income effect
The income effect is the movement
from point C to point B B
If X is a normal good,
the individual will buy
more because “real”
income increased A C U2 U1
Quantity of X

16. Changes in a Good’s Price
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

17. 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 QD
When price rises, both effects lead to a drop in QD

18. 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 QD, but the income effect leads to a rise in QD
When price falls, the substitution effect leads to a rise in QD, but the income effect leads to a fall in QD

19. Giffen’s Paradox
If the income effect of a price change is strong enough, there could be a positive relationship between price and QD
An increase in price leads to a drop in real income
Since the good is inferior, a drop in income causes QD to rise
Thus, a rise in price leads to a rise in QD

20. Summary of Income & Substitution Effects
Utility maximization implies that (for normal goods) a fall in price leads to an increase in QD
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

21. Summary of Income & Substitution Effects
Utility maximization implies that (for normal goods) a rise in price leads to a decline in QD
The substitution effect causes less to be purchased as the individual moves along an indifference curve
The income effect causes less to be purchased because the resulting drop in purchasing power moves the individual to a lower indifference curve

22. Summary of Income & Substitution Effects
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. The Individual’s Demand Curve
An individual’s demand for X1 depends on preferences, all prices, and income:
X1* = d1(P1,P2,…,Pn,I)
It may be convenient to graph the individual’s demand for X1 assuming that income and the prices of other goods are held constant

24. The Individual’s Demand Curve
Quantity of Y
As the price
of X falls... PX X1
PX1 U1
I = PX1 + PY X2
PX2 U2
I = PX2 + PY X3
PX3 U3
I = PX3 + PY dX
…quantity of X
demanded rises.
Quantity of X
Quantity of X

25. The Individual’s Demand Curve
An individual 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

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

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

28. Compensated 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

29. Compensated Demand Curves
An alternative approach holds real income (or utility) constant while examining reactions to changes in PX
The effects of the price change are “compensated” so as to constrain the individual to remain on the same indifference curve
Reactions to price changes include only substitution effects

30. 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* = hX(PX,PY,U)

31. Compensated Demand Curves
Holding utility constant, as price falls...
Quantity of Y PX X1
PX1 hX
…quantity demanded
rises. X2
PX2 X3
PX3 U2
Quantity of X
Quantity of X

32. Compensated & Uncompensated DemandPX X2
PX2
At PX2, the curves intersect because
the individual’s income is just sufficient to attain utility level U2 dX hX
Quantity of X

33. Compensated & Uncompensated Demand
X1* X1
PX1
At prices above PX2, income compensation is positive because the individual needs some help to remain on U2 PX
PX2 dX hX
Quantity of X

34. Compensated & Uncompensated DemandPX
X3* X3
PX3
At prices below PX2, income compensation is negative to prevent an increase in utility from a lower price
PX2 dX hX
Quantity of X

35. 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

36. 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 indirect utility function is

37. Compensated Demand Functions
To obtain the compensated demand functions, we can solve the indirect utility function for I and then substitute into the Marshallian demand functions

38. Compensated Demand Functions
Demand now depends on utility rather than income
Increases in PX reduce the amount of X demanded
only a substitution effect

39. A Mathematical Examination of a Change in Price
Our goal is to examine how the demand for good X changes when PX changes
dX/PX
Differentiation of the first-order conditions from utility maximization can be performed to solve for this derivative
However, this approach is cumbersome and provides little economic insight

40. A Mathematical Examination of a Change in Price
Instead, we will use an indirect approach
Remember the expenditure function
minimum expenditure = E(PX,PY,U)
Then, by definition
hX (PX,PY,U) = dX [PX,PY,E(PX,PY,U)]
Note that the two demand functions are equal when income is exactly what is needed to attain the required utility level

41. A Mathematical Examination of a Change in Price
hX (PX,PY,U) = dX [PX,PY,E(PX,PY,U)]
We can differentiate the compensated demand function and get

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

43. 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 necessary expenditure levels
This is the mathematical representation of the income effect

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

45. The Slutsky Equation Note that E/PX = X
A $1 increase in PX raises necessary expenditures by X dollars
$1 extra must be paid for each unit of X purchased

46. The Slutsky Equation
The utility-maximization hypothesis shows that the substitution and income effects arising from a price change can be represented by

47. 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 will always be negative

48. 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

49. Revealed Preference & the Substitution Effect
The theory of revealed preference was proposed by Paul Samuelson in the late 1940s
The theory defines a principle of rationality based on observed behavior and then uses it to approximate an individual’s utility function

50. Revealed Preference & the Substitution Effect
Consider two bundles of goods: A and B
If the individual can afford to purchase either bundle but chooses A, we say that A had been revealed preferred to B
Under any other price-income arrangement, B can never be revealed preferred to A

51. Revealed Preference & the Substitution Effect
Quantity of Y
Suppose that, when the budget constraint is
given by I1, A is chosen
A must still be preferred to B when income
is I3 (because both A and B are available) A
If B is chosen, the budget constraint must be similar to that given by I2 where A is not available B I2 I1 I3
Quantity of X

52. Negativity of the Substitution Effect
Suppose that an individual is indifferent between two bundles: C and D
Let PXC,PYC be the prices at which bundle C is chosen
Let PXD,PYD be the prices at which bundle D is chosen

53. Negativity of the Substitution Effect
Since the individual is indifferent between C and D
When C is chosen, D must cost at least as much as C
PXCXC + PYCYC ≤ PXDXD + PYDYD
When D is chosen, C must cost at least as much as D
PXDXD + PYDYD ≤ PXCXC + PYCYC

54. Negativity of the Substitution Effect
Rearranging, we get
PXC(XC - XD) + PYC(YC -YD) ≤ 0
PXD(XD - XC) + PYD(YD -YC) ≤ 0
Adding these together, we get
(PXC – PXD)(XC - XD) + (PYC – PYD)(YC - YD) ≤ 0

55. Negativity of the Substitution Effect
Suppose that only the price of X changes (PYC = PYD)
(PXC – PXD)(XC - XD) ≤ 0
This implies that price and quantity move in opposite direction when utility is held constant
the substitution effect is negative

56. Mathematical Generalization
If, at prices Pi0 bundle Xi0 is chosen instead of bundle Xi1 (and bundle Xi1 is affordable), then
Bundle 0 has been “revealed preferred” to bundle 1

57. Mathematical Generalization
Consequently, at prices that prevail when bundle 1 is chosen (Pi1), then
Bundle 0 must be more expensive than bundle 1

58. Strong Axiom of Revealed Preference
If commodity bundle 0 is revealed preferred to bundle 1, and if bundle 1 is revealed preferred to bundle 2, and if bundle 2 is revealed preferred to bundle 3,…,and if bundle k-1 is revealed preferred to bundle k, then bundle k cannot be revealed preferred to bundle 0

59. expenditure = E(PX,PY,U0)
Consumer Welfare
The expenditure function shows the minimum expenditure necessary to achieve a desired utility level (given prices)
The function can be denoted as
expenditure = E(PX,PY,U0)
where U0 is the “target” level of utility

60. Consumer Welfare
One way to evaluate the welfare cost of a price increase (from PX0 to PX1) would be to compare the expenditures required to achieve U0 under these two situations
expenditure at PX0 = E0 = E(PX0,PY,U0)
expenditure at PX1 = E1 = E(PX1,PY,U0)

61. Consumer Welfare
The loss in welfare would be measured as the increase in expenditures required to achieve U0
welfare loss = E0 – E1
Because E1 > E0, this change would be negative
the price increase makes the person worse off

62. Consumer Welfare
Remember that the derivative of the expenditure function with respect to PX is the compensated demand function (hX)
The change in necessary expenditures brought about by a change in PX is given by the quantity of X demanded

63. Consumer Welfare
To evaluate the change in expenditure caused by a price change (from PX0 to PX1), we must integrate the compensated demand function
This integral is the area to the left of the compensated demand curve between PX0 and PX1

64. Consumer Welfare When the price rises from PX0 to PX1,
the consumer suffers a loss in welfare
welfare loss
PX1 X1
PX0 X0 hX
Quantity of X

65. Consumer Welfare
Because a price change generally involves both income and substitution effects, it is unclear which compensated demand curve should be used
Do we use the compensated demand curve for the original target utility (U0) or the new level of utility after the price change (U1)?

66. Consumer Welfare PX
When the price rises from PX0 to PX1, the actual market reaction will be to move from A to C
The consumer’s utility falls from U0 to U1 C
PX1 A
PX0 dX
hX(U0)
hX(U1) X1 X0
Quantity of X

67. Consumer Welfare PX
Is the consumer’s loss in welfare best described by area PX1BAPX0 [using hX(U0)] or by area PX1CDPX0 [using hX(U1)]?
Is U0 or U1 the appropriate utility target? C B
PX1 A
PX0 D dX
hX(U0)
hX(U1) X1 X0
Quantity of X

68. Consumer Welfare PX
We can use the Marshallian demand curve as a compromise.
The area PX1CAPX0 falls between the sizes of the welfare losses defined by hX(U0) and hX(U1) C B
PX1 A
PX0 D dX
hX(U0)
hX(U1) X1 X0
Quantity of X

69. Loss of Consumer Welfare from a Rise in Price
Suppose that the compensated demand function for X is given by
the welfare loss from a price increase from PX = 0.25 to PX = 1 is given by

70. Loss of Consumer Welfare from a Rise in Price
If we assume that the initial utility level (V) is equal to 2,
loss = 4(1)0.5 – 4(0.25)0.5 = 2
If we assume that the utility level (V) falls to 1 after the price increase (and used this level to calculate welfare loss),
loss = 2(1)0.5 – 2(0.25)0.5 = 1

71. Loss of Consumer Welfare from a Rise in Price
Suppose that we use the Marshallian demand function instead
the welfare loss from a price increase from PX = 0.25 to PX = 1 is given by

72. Loss of Consumer Welfare from a Rise in Price
Because income (I) is equal to 2,
loss = 0 – (-1.39) = 1.39
This computed loss from the Marshallian demand function is a compromise between the two amounts computed using the compensated demand functions

73. Important Points to Note:
Proportional changes in all prices and income do not shift the individual’s budget constraint and therefore do not alter the quantities of goods chosen
demand functions are homogeneous of degree zero in all prices and income

74. Important Points to Note:
When purchasing power changes (income changes but prices remain the same), budget constraints shift
for normal goods, an increase in income means that more is purchased
for inferior goods, an increase in income means that less is purchased

75. Important Points to Note:
A fall in the price of a good causes substitution and income effects
For a normal good, both effects cause more of the good to be purchased
For inferior goods, substitution and income effects work in opposite directions
A rise in the price of a good also causes income and substitution effects
For normal goods, less will be demanded
For inferior goods, the net result is ambiguous

76. Important Points to Note:
The Marshallian demand curve summarizes the total quantity of a good demanded at each price
changes in price prompt movemens along the curve
changes in income, prices of other goods, or preferences may cause the demand curve to shift

77. Important Points to Note:
Compensated demand curves illustrate movements along a given indifference curve for alternative prices
these are constructed by holding utility constant
they exhibit only the substitution effects from a price change
their slope is unambiguously negative (or zero)

78. Important Points to Note:
Income and substitution effects can be analyzed using the Slutsky equation
Income and substitution effects can also be examined using revealed preference
The welfare changes that accompany price changes can sometimes be measured by the changing area under the demand curve