Income and

Substitution Effects

PowerPoint Slides prepared by:

Andreea CHIRITESCU
Eastern Illinois University
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
1
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Marshallian Demand Elasticities
• Marshallian demand elasticities
– Marshallian demand function: x(px,py,I)

1. Price elasticity of demand, ex, px

– Measures the proportionate change in
quantity demanded
• In response to a proportionate change in a
good’s own price
x / x x px
ex , p x   
px / px px x
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
2
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Marshallian Demand Elasticities
2. Income elasticity of demand, ex,I
– Measures the proportionate change in
quantity demanded
• In response to a proportionate change in
income
x / x x I
ex , I   
I / I I x

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
3
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Marshallian Demand Elasticities
3. Cross-price elasticity of demand, ex,py
– Measures the proportionate change in
quantity of x demanded
• In response to a proportionate change in the
price of some other good (y)
x / x x p y
ex , p y   
p y / p y p y x

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
4
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Price elasticity of demand
• The own price elasticity of demand is
always negative
– The only exception is Giffen’s paradox
• The size of the elasticity is important
– If ex,px < -1, demand is elastic

– If ex,px > -1, demand is inelastic

– If ex,px = -1, demand is unit elastic

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
5
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Price elasticity of demand
• The own price elasticity of demand is
always negative
• The size of the elasticity is important
– If ex,px = -1, demand is unit elastic
Changes in x and px are of the same
proportionate size. That is, a 1 percent
increase in price leads to a decrease of 1
percent in quantity demanded. In this case,
demand is said to be ‘‘unit-elastic.’’
6
 Price Elasticity of Demand
• The size of the elasticity is important (Cont…)
– If ex,px < -1, demand is elastic

Alternatively, if 𝜖𝑥,𝑝𝑥 < −1 , then quantity

changes are proportionately larger than price
changes, and we say that demand is ‘‘elastic.’’
For example, if 𝜖𝑥,𝑝𝑥 = −3 , each 1 percent
increase in price leads to a decrease of 3
percent in quantity demanded.
7
 Price Elasticity of Demand
• The size of the elasticity is important (Cont…)
– If ex,px > -1, demand is inelastic

Finally, if ex, 𝜖𝑥,𝑝𝑥 > −1 , then demand is

inelastic, and quantity changes are
proportionately smaller than price

changes. A value of 𝜖𝑥,𝑝𝑥 = −0.3, for example,

means that a 1 percent increase in price leads to
a decrease in quantity demanded of 0.3 percent.

8
 Price Elasticity of Demand
• Total spending on x = pxx
𝜕(𝑝𝑥 𝑥) 𝜕𝑥 𝜕𝑝𝑥
= 𝑝𝑥 . +𝑥
𝜕𝑝𝑥 𝜕𝑝𝑥 𝜕𝑝𝑥
𝜕(𝑝𝑥 𝑥) 𝜕𝑥
= 𝑝𝑥 . +𝑥
𝜕𝑝𝑥 𝜕𝑝𝑥
𝜕(𝑝𝑥 𝑥) 𝑥 𝜕𝑥
= 𝑝𝑥 . +𝑥
𝜕𝑝𝑥 𝑥 𝜕𝑝𝑥
𝜕(𝑝𝑥 𝑥) 𝑝𝑥 𝜕𝑥
= 𝑥( . + 1)
𝜕𝑝𝑥 𝑥 𝜕𝑝𝑥
𝜕(𝑝𝑥 𝑥)
= 𝑥(𝑒𝑥,𝑝𝑥 + 1)
𝜕𝑝𝑥
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
9
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Elasticity and total Expenditure
Unit Elastic
p Q TE

20 100 2000

25 80 2000

20 -20 0

4 100 400

5 80 400

20 -20 0

5 100 500

4 125 500

-25 25 0

. 10
 Elasticity and total Expenditure
Elastic

p Q TE
case 1 20 100 2000
25 75 1875
20 -25 -125
case 2 4 100 400
5 75 375
20 -25 -25
case 3 5 100 500
4 130 520
-25 30 20

. 11
 Elasticity and total Expenditure
Inelastic

p Q TE
case 1 20 100 2000
25 85 2125
20 -15 125
case 2 4 100 400
5 90 450
20 -10 50
case 3 5 100 500
4 110 440
-25 10 -60

. 12
 Price Elasticity of Demand

• If ex,px > -1, demand is inelastic

– Price and total spending move in the
same direction
• If ex,px < -1, demand is elastic
– Price and total spending move in
opposite directions

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
13
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Compensated Price Elasticities
• Compensated price elasticities
– Compensated demand function, xc(px,py,U)

1. Compensated own-price elasticity of

demand, exc,px
– Measures the proportionate compensated
change in quantity demanded
• In response to a proportionate change in a
good’s own price
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
14
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Compensated Price Elasticities
2. Compensated cross-price elasticity of
demand, exc,py
– Measures the proportionate
compensated change in quantity of x
demanded
• In response to a proportionate change in the
price of another good, y

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
15
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Compensated Price Elasticities
x / x x px
c
xcc c
( px , p y , U ) px
exc , p    c   c
x
px / px px x px x
x / x x p y x ( px , p y ,U ) p y
c c c c

exc , p    c   c
y
p y / p y p y x p y x
using the Slutsky equation:
px x px x c px x
  ex , px  c    x   exc, px  sx ex , I
x px x px x I
where s x  p x x / I is the share of total income
devoted to the purchase of good x
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
16
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Compensated Price Elasticities
Slutsky Equation is
𝜕𝑥 𝜕𝑥 𝑐 𝜕𝑥
= −𝑥
𝜕𝑝𝑥 𝜕𝑝𝑥 𝜕𝐼
𝑝𝑥
Divide by factor
𝑥
𝑝𝑥 𝜕𝑥 𝑝𝑥 𝜕𝑥 𝑐 𝑝𝑥 𝜕𝑥
. = . − .𝑥
𝑥 𝜕𝑝𝑥 𝑥 𝜕𝑝𝑥 𝑥 𝜕𝐼
𝑝𝑥 𝜕𝑥 𝑐 𝑝𝑥 𝜕𝑥 𝐼
𝑒𝑥,𝑝𝑥 = . − .𝑥 .
𝑥 𝜕𝑝𝑥 𝑥 𝜕𝐼 𝐼
𝑝𝑥 𝜕𝑥 𝑐 𝑥𝑝𝑥 𝐼 𝜕𝑥
𝑒𝑥,𝑝𝑥 = . − . .
𝑥 𝜕𝑝𝑥 𝐼 𝑥 𝜕𝐼
𝑒𝑥,𝑝𝑥 = 𝑒𝑥 𝑐 ,𝑝𝑥 − 𝑠𝑥 𝑒𝑥,𝐼
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
17
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Compensated Price Elasticities
• The Slutsky equation shows
– That the compensated and
uncompensated price elasticities will be
similar if
• The share of income devoted to x is small
• The income elasticity of x is small

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
18
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Relationships among Demand Elasticities
• Homogeneity
– Demand functions are homogeneous of
degree zero in all prices and income
– Euler’s theorem for homogenous functions
shows that
x x x
0  px   py  I
px p y I
divide by x:
0  ex , px  ex , p y  ex , I
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
19
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Relationships among Demand Elasticities
• Engel aggregation
– Engel’s law: income elasticity of demand
for food items is <1
• Income elasticity of demand for all nonfood
items must be >1
– Differentiate the budget constraint with
respect to income
x y
1  px   p y 
I I
x xI y y I
1  px    p y    s x ex , I  s y e y , I
I xI I y I
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
20
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Relationships among Demand Elasticities
• Cournot aggregation
– The size of the cross-price effect of a
change in px on the quantity of y
consumed is restricted because of the
budget constraint
– Differentiate the budget constraint with
respect to px

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
21
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Relationships among Demand Elasticities
• Cournot aggregation
I x y
 0  px   x  py 
px px px
x px x px y px y
0  px     x   py   
px I x I px I y
0  sx ex , px  sx  s y ey , px
sx ex , px  s y ey , px   sx

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
22
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 5.5 Demand Elasticities: The Importance of
Substitution Effects
1. Cobb-Douglas: U(x,y)=xy, +=1
• Demand functions: x(px,py,I)=I/px, and
y(px,py,I)=I/py=(1- )I/py
• Elasticities:
x px I px
ex , px     2   1
px x px  I px 
x py py
ex , p y    0 0
p y x x
x I  I
ex , I     1
I x px  I px 
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
23
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 5.5 Demand Elasticities: The Importance of
Substitution Effects
1. Cobb-Douglas:
• Because sx =  and sy = 
Homogeneity:
ex , px  ex , p y  ex , I  1  0  1  0
Engel aggregation :
sx ex , I  s y ey , I   1   1      1
Cournot aggregation :
sx ex , px  s y ey , px    (1)    0     sx

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
24
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 5.5 Demand Elasticities: The Importance of
Substitution Effects
1. Cobb-Douglas:
• Using the Slutsky equation in elasticity form to
derive the compensated price elasticity:

e c
x , px  ex , px  sx ex , I  1   (1)    1   

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
25
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.