Course: Microeconomics
Text: Varians Intermediate
Microeconomics
In Chapter 6, we talk about how demand
changes when price and income change
individually.
In this chapter, we want to further analyze
how the change in price changes the
demand.
In particular, we decompose the change in
quantity demanded due to price change
into substitution effect and income effect.
2
What happens when a commoditys price
decreases?
Substitution effect: the commodity is
relatively cheaper, so consumers use
more of it, instead of other commodities,
which are now relatively more expensive.
Income effect: the consumers budget
of $m can purchase more than before,
as if the consumers income rose, with
consequent income effects on quantities
demanded. 3
x
2
x
1
Original choice
Consumers budget is $m.
2
p
m
4
x
1
Lower price for commodity 1
pivots the constraint outwards.
Consumers budget is $y.
x
2
2
p
m
5
x
1
Lower price for commodity 1
pivots the constraint outwards.
Consumers budget is $m.
x
2
Now only $m are needed to buy the
original bundle at the new prices,
as if the consumers income has
increased by $m -- $m.
2
p
m
2
'
p
m
6
Slutsky asserted that if, at the new
prices,
If less income is needed to buy the original
bundle then real income is increased
If more income is needed to buy the
original bundle then real income is
decreased
7
Changes to quantities demanded due to
the change in relative prices, keeping
income just enough to buy the original
bundle, are the (pure) substitution effect of
the price change.
Changes to quantities demanded due to
the change in real income are the income
effect of the price change.
8
Slutsky discovered that changes to
demand from a price change are always
the sum of a pure substitution effect
and an income effect.
n
i
s
i i
x x x
9
x
2
x
1
x
2
x
1
10
x
2
x
1
x
2
x
1
11
x
2
x
1
x
2
x
1
12
x
2
x
1
x
2
x
2
x
1
x
1
13
x
2
x
1
x
2
x
2
x
1
x
1
14
x
2
x
1
x
2
x
2
x
1
x
1
Lower p
1
makes good 1 relatively
cheaper and causes a substitution
from good 2 to good 1.
(x
1
,x
2
) (x
1
,x
2
) is the
pure substitution effect.
15
Substitution effect is always negatively
related to the price change.
Note that the portion of the yellow
compensated budget line below x
1
is inside
the budget set of the original budget, thus
these bundles should be less preferred than
the original bundle.
As a result, the consumer must choose a
point at or more than x
1
with the
compensated budget, and as a result, the
substitution effect is positive for a price
decrease.
16
x
2
x
1
x
2
x
2
x
1
x
1
(x
1
,x
2
)
17
x
2
x
1
x
2
x
2
x
1
x
1
(x
1
,x
2
)
The income effect is
(x
1
,x
2
) (x
1
,x
2
).
18
x
2
x
1
x
2
x
2
x
1
x
1
(x
1
,x
2
)
The change to demand due to
lower p
1
is the sum of the
income and substitution effects,
(x
1
,x
2
) (x
1
,x
2
).
19
Most goods are normal (i.e. demand
increases with income).
The substitution and income effects
reinforce each other when a normal goods
own price changes.
20
x
2
x
1
x
2
x
2
x
1
x
1
(x
1
,x
2
)
Good 1 is normal because
higher income increases
demand, so the income
and substitution
effects reinforce
each other.
21
Since both the substitution and income effects
increase demand when own-price falls, a
normal goods ordinary demand curve slopes
down.
The Law of (Downward-Sloping) Demand
therefore always applies to normal goods.
22
Some goods are inferior (i.e. demand is
reduced when income is higher.)
The substitution and income effects
oppose each other when an inferior goods
own price changes.
23
x
2
x
1
x
2
x
1
24
x
2
x
1
x
2
x
1
25
x
2
x
1
x
2
x
1
26
x
2
x
1
x
2
x
2
x
1
x
1
27
x
2
x
1
x
2
x
2
x
1
x
1
The pure substitution effect is as for
a normal good. But, .
28
x
2
x
1
x
2
x
2
x
1
x
1
(x
1
,x
2
)
The pure substitution effect is as for a
normal good. But, the income effect is
in the opposite direction.
29
x
2
x
1
x
2
x
2
x
1
x
1
(x
1
,x
2
)
The overall changes to demand are
the sums of the substitution and
income effects.
30
In rare cases of extreme income-inferiority,
the income effect may be larger than the
substitution effect, causing quantity
demanded to fall as own-price rises.
Such goods are Giffen goods.
31
x
2
x
1
x
2
x
1
A decrease in p
1
causes
quantity demanded of
good 1 to fall.
32
x
2
x
1
x
2
x
1
x
1
x
2
A decrease in p
1
causes
quantity demanded of
good 1 to fall.
33
x
2
x
1
x
2
x
2
x
1
x
1
x
1
x
2
Substitution effect
Income effect
A decrease in p
1
causes
quantity demanded of
good 1 to fall.
34
Giffen good can only result when the income
effect of an inferior good is so strong that it
dominates the substitution effect.
This may be possible for poor households
where the low-quality necessity has taken up
a large portion of expenditure.
This case is very rare, even if exists, so we
have confidence that the Law of Demand
almost always holds.
35
If we denote m as the income required to
obtain the original bundle at the new
prices, so that
m=p
1
x
1
+ p
2
x
2
and m=p
1
x
1
+ p
2
x
2
.
Thus the change in real income is
m m = (p
1
p
1
) x
1
Or
1 1
x p m
36
The substitution effect is
The Income effect is
Total Effect
) , ( ) ' , ' (
1 1 1 1 1
m p x m p x x
s
) ' , ' ( ) , ' (
1 1 1 1 1
m p x m p x x
n
n s
x x m p x m p x x
1 1 1 1 1 1 1
) , ( ) , ' (
37
In terms of derivative (or rate of change):
Which is known as the Slutsky Equation.
(This is just a rough presentation. The tools
need for formal derivations is not covered in
this class.)
) (
) (
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
x
m
x
p
x
p
x
x
m
x
p
x
p
x
p
m
m
x
p
x
p
x
s
s
s
38
39
40
41
Slutskys method of decomposition is not
the only reasonable way.
Hicks proposed another way of holding
real income constant.
Instead of compensating him to be able to
buy back the original bundle, Hicks
method compensates the consumer to buy
back a bundle that gives him the same
utility as before.
42
43
Hicks Substitution Effect is also negative,
because of the convex preference. (It can
also be shown by revealed preference.)
The nominal income required to maintain
the utility constant is less than the one
required to buy back the same bundle. It
implies a larger income effect for a price
decrease, but a smaller income effect for a
price increase.
44
If government wants to impose tax to support
public expenditure, or to punish consumption
of a good, say, due to pollution, various
means can be used.
Here, given the revenue are the same in
equilibrium, how do the effects of income tax
and quantity tax on good 1 differ?
(Note: Income and tax rates are regarded as
given for consumers. The tax rate is adjusted
so that at equilibrium the tax revenue is the
same.)
45
46
Income tax corresponds to an inward shift
of budget line.
Quantity tax corresponds to an inward
rotation of the budget line.
When the revenues are held the same for
comparison, the budget line for the income
tax must pass through the optimal point for
quantity tax.
(Note: The tax revenue is tx
1
*
, where x
1
*
is
the optimal quantity under quantity tax.)
47
With the same tax revenue, the utility level
attained is higher with income tax than
with the quantity tax.
But quantity tax has a stronger effect in
reducing the consumption of good 1 than
income tax.
48
Consider a similar case. Now a tax is
imposed to reduce consumption of certain
good, but at the same time, an equivalent
amount is rebated (given back) to the
consumer.
Again, consumer has to take the rebate
and tax rate constant for his decision.
49
50
Note that the new consumption bundle
must be on the original budget line,
because in equilibrium, the tax amount
and rebate are the same.
The consumer has become worse off after
this quantity tax and rebate program.
51
In this chapter, a decomposition of price
effect on quality demand is introduced.
Substitution effect: effect of change of price
holding real income constant.
Income effect: effect of change in real income.
For normal goods, both effects are negative
w.r.t. a price rise.
For inferior goods, sub. effect is negative, but
income effect is positive w.r.t. a price rise.
Giffen goods can only be inferior goods with
very strong income effect.
52
