General Understanding:
Some Questions
– How does the concept of indifference curves aid in understanding the separation of substitution and
income effects?
– Explain how changes in price and income are reflected on an indifference curve.
Substitution Effect:
– On an indifference curve, describe how a decrease in the price of good X affects the consumer's choice
and the shape of the indifference curve.
– If good Y is a perfect substitute for good X, how would the indifference curve be affected by a decrease in
the price of X?
Income Effect:
– Using an indifference curve, illustrate the impact of an increase in income on the consumption of goods X
and Y when both are normal goods.
– Explain how the indifference curve shifts or rotates when there is an increase in the price of a luxury
good if it is considered a normal good.
Combining Effects:
– Describe how a simultaneous decrease in the price of good X and an increase in income affect the
consumer's optimal choice, considering the substitution and income effects.
– Can the substitution and income effects work in opposite directions? Provide an example using an
indifference curve.
Giffen Goods and Indifference Curves:
– Discuss how a Giffen good might behave on an indifference curve when its price increases. What role do
income and substitution effects play in this scenario?
Consumer Preferences and Indifference Curves:
– Explain how the shape of an indifference curve reflects consumer preferences regarding substitutes and
complements.
– How do convex and concave indifference curves contribute to understanding consumer reactions to
Price Change: Income and
Substitution Effects
THE IMPACT OF A PRICE
CHANGE
Economists often separate the
impact of a price change into two
components:
– the substitution effect; and
– the income effect.
THE IMPACT OF A PRICE
CHANGE
The substitution effect involves the
substitution of good x1 for good x2 or vice-
versa due to a change in relative prices of
the two goods.
The income effect results from an increase
or decrease in the consumer’s real income
or purchasing power as a result of the
price change.
The sum of these two effects is called the
price effect.
THE IMPACT OF A PRICE
CHANGE
The decomposition of the price effect
into the income and substitution
effect can be done in several ways
There are two main methods:
(i) The Hicksian method; and
(ii) The Slutsky method
THE HICKSIAN METHOD
Sir John R.Hicks (1904-1989)
Awarded the Nobel Laureate in
Economics (with Kenneth J. Arrrow)
in 1972 for work on general
equilibrium theory and welfare
economics.
THE HICKSIAN METHOD
X2 Optimal bundle is Ea, on
indifference curve I1.
Ea
I1
xa X1
THE HICKSIAN METHOD
X2 A fall in the price of X1
The budget line pivots
P * out from P
Ea
I1
xa X1
THE HICKSIAN METHOD
The new optimum is
X2
Eb on I2.
The Total Price
Effect is xa to xb
Eb
Ea I2
I1
xa xb X1
THE HICKSIAN METHOD
To isolate the substitution effect we ask….
“what would the consumer’s optimal
bundle be if s/he faced the new lower price
for X1 but experienced no change in real
income?”
This amounts to returning the consumer
to the original indifference curve (I 1)
THE HICKSIAN METHOD
The new optimum is
X2
Eb on I2.
The Total Price
Effect is xa to xb
Eb
Ea I2
I1
xa xb X1
THE HICKSIAN METHOD
Draw a line parallel to
X2 the new budget line and
tangent to the old
indifference curve
Eb
Ea I2
I1
xa xb X1
THE HICKSIAN METHOD
The new optimum on I1 is
X2 at Ec. The movement from
Ea to Ec (the increase in
quantity demanded from
Xa to Xc) is solely in
response to a change in
Eb
Ea I2 relative prices
Ec I1
xa xc xb X1
THE HICKSIAN METHOD
X2 This is the
substitution effect.
Eb
Ea I2
Ec
I1
X1
Xa Substitution Xc
Effect
THE HICKSIAN METHOD
To isolate the income effect …
Look at the remainder of the total
price effect
This is due to a change in real
income.
THE HICKSIAN METHOD
The remainder of the total
X2 effect is due to a change
in real income. The
increase in real income is
evidenced by the
movement from I1 to I2
Eb
Ea I2
Ec
I1
X1
Xc Income Effect Xb
THE HICKSIAN METHOD
X2
Eb
Ea I2
Ec
I1
xa xc xb X1
Sub Income
Effect Effect
HICKSIAN ANALYSIS and DEMAND CURVES
P
A fall in price
M 1 p1 x1 p2 x2 from p1 to p1*
B
AC
M 1 p1 x1 p2 x2
P X1
A Marshallian Demand
P1
Curve (A & B)
B Hicksian Demand
P1* C Curve (A & C)
X1
HICKSIAN ANALYSIS and DEMAND
CURVES
Hicksian (compensated) demand
curves cannot be upward-sloping
(i.e. substitution effect cannot be
positive)
Small Case Study
Background:
Consider a small town with two popular coffee shops
and a tea house. The residents consume both coffee
and tea, and the price of coffee has recently
decreased.
Scenario:
Substitution Effect:
With the decrease in coffee prices, consumers
notice the affordability of coffee compared to tea.
Some regular tea drinkers start substituting their
tea purchases with coffee, attracted by the
relative price change.
Coffee sales increase while tea sales decrease.
2.
Background: Imagine a society where smartphones are considered a normal
good, and consumers have a certain income level. The price of smartphones
has recently decreased.
Scenario:
Income Effect:
– As smartphone prices fall, consumers effectively experience an increase
in their real income.
– With the extra purchasing power, some consumers buy more advanced
smartphones or upgrade their existing ones.
– Smartphone sales increase due to the income effect.
THE SLUTSKY METHOD
Eugene Slutsky (1880-1948)
Russian economist expelled from the
University of Kiev for participating in
student revolts.
In his 1915 paper, “On the theory of
the Budget of the Consumer” he
introduced “Slutsky Decomposition”.
THE SLUTSKY METHOD
X2 Optimal bundle is Ea, on
indifference curve I1.
Ea
I1
xa X1
THE SLUTSKY METHOD
X2 A fall in the price of X1
The budget line pivots
P * out from P
Ea
I1
xa X1
THE SLUTSKY METHOD
The new optimum is
X2
Eb on I2.
The Total Price
Effect is xa to xb
Eb
Ea I2
I1
xa xb X1
THE SLUTSKY METHOD
Slutsky claimed that if, at the new prices,
– less income is needed to buy the original
bundle then “real income” has increased
– more income is needed to buy the
original bundle then “real income” has
decreased
Slutsky isolated the change in demand due
only to the change in relative prices by
asking “What is the change in demand
when the consumer’s income is adjusted
so that, at the new prices, s/he can just
afford to buy the original bundle?”
THE SLUTSKY METHOD
To isolate the substitution effect we
adjust the consumer’s money
income so that s/he change can just
afford the original consumption
bundle.
In other words we are holding
purchasing power constant.
THE SLUTSKY METHOD
The new optimum is
X2
Eb on I2.
The Total Price
Effect is xa to xb
Eb
Ea I2
I1
xa xb X1
THE SLUTSKY METHOD
Draw a line parallel
X2
to the new budget
line which passes
through the point
Ea.
Eb
Ea I2
I1
xa xb X1
THE SLUTSKY METHOD
The new optimum
X2 on I3 is at Ec. The
movement from Ea
to Ec is the
substitution effect
Eb
Ea I2
Ec
I3
xa xc xb X1
THE SLUTSKY METHOD
The new optimum
X2 on I3 is at Ec. The
movement from Ea
to Ec is the
substitution effect
Eb
Ea I2
Ec
I3
xa xc X1
Substitution Effect
THE SLUTSKY METHOD
The remainder of
X2 the total price effect
is the Income Effect.
The movement from
Ec to Eb.
Eb
Ea I2
Ec
I3
xc xb X1
Income Effect
THE SLUTSKY METHOD for NORMAL
GOODS
Most goods are normal (i.e. demand
increases with income).
The substitution and income effects
reinforce each other when a normal
good’s own price changes.
THE SLUTSKY METHOD for
NORMAL GOODS
The income and
X2 substitution effects
reinforce each
other.
Eb
Ea I2
Ec
I3
xa xc xb
X1
THE SLUTSKY METHOD for NORMAL
GOODS
Since both the substitution and
income effects increase demand
when own-price falls, a normal
good’s ordinary demand curve
slopes downwards.
The “Law” of Downward-Sloping
Demand therefore always applies to
normal goods.
THE SLUTSKY EQUATION
Let M 1 p1 x1 p2 x 2
be the original budget constraint
and let
M 2 p1 x1 p2 x 2
represent the budget constraint after the
Slutsky compensating variation in income
has been carried out.
THE SLUTSKY EQUATION
Demand for x1 is
X2 M2 < M1
x1 x p1 , p2 , M
d
M 1 p1 x1 p2 x2
Ea
xa
X1
M 2 p1 x1 p2 x2
THE SLUTSKY EQUATION
M2 - M1
M M 2 M 1
p1 x1
p2 x 2 - p1 x1 p2 x 2
M M 2 M 1 p1 x1 p2 x 2 - p1 x1 p2 x 2
M M 2 M 1 p1 x1 - p1 x1
M M 2 M 1 x1 p1 - p1
M x1p1 as
p1
- p1 p1
gives the change in money
income needed to
consume the original M=x1p1
bundle of goods (at EA)
THE SLUTSKY EQUATION
The demand curve holding M
constant is given by
x1 x d
p1 ,
p2 , M 1 x d
p1 , p2 , M 1 (1)
which is the change in demand for x1 due to
the change in its own price, holding M and
the price of x2 constant
THE SLUTSKY EQUATION
The income effect is given by
x m x d p1 , p2 , M 1 x d p1 , p2 , M 2 (2)
The change in demand due to the Slutsky
substitution effect is given by
x s x d p1 , p2 , M 2 x d p1 , p2 , M 1 (3)
THE SLUTSKY EQUATION
Given
x1 x d
p , M x p , p , M
p1 , 2 1
d
1 2 1 (1)
x m x p , p , M x p , p , M
d
1 2 1
d
1 2 2 (2)
x s x p , p , M x p , p , M
d
1 2 2
d
1 2 1 (3)
Claim
x1 x s x m (4)
Show this by substituting equations (1), (2)
and (3) into equation (4)
THE SLUTSKY EQUATION
x1 x s x m
Divide across by p1
x1 x s x m
p1 p1 p1
Recall M x1p1
so p1 () M x1
THE SLUTSKY EQUATION
Substituting
p1 ()M x1
x1 xs xm
p1 p1 p1
Gives x1 x s x m THE
x1 SLUTSKY
p1 p1 M EQUATION
THE SLUTSKY METHOD: INFERIOR
GOODS
Some goods are (sometimes) inferior
(i.e. demand is reduced by higher
income).
The substitution and income effects
“oppose” each other when an
inferior good’s own price changes.
THE SLUTSKY METHOD: INFERIOR
GOODS
The substitution
X2 effect is as per
usual. But, the
income effect is
in the opposite
Eb direction.
I2
Ea
Ec
I3
xa xb xc
X1
xa to xc
xc to xb
GIFFEN GOODS
In rare cases of extreme inferiority,
the income effect may be larger in
size than the substitution effect,
causing quantity demanded to rise
as own price falls.
Such goods are Giffen goods.
Giffen goods are very inferior goods.
THE SLUTSKY METHOD for
INFERIOR GOODS
In rare cases of
X2 extreme income-
inferiority, the income
effect may be larger
Eb in size than the
I2 substitution effect,
causing quantity
Ea demanded to fall as
Ec own-price falls.
I3
xb xa xc
xa to xc X1
xc to xb
SLUTSKY’S EFFECT FOR
GIFFEN GOODS
Slutsky’s decomposition of the effect
of a price change into a pure
substitution effect and an income
effect thus explains why the “Law” of
Downward-Sloping Demand is
violated for very inferior goods.
DECOMPOSITION of TOTAL PRICE EFFECT:
PERFECT COMPLEMENTS
X2 A fall in the price of X1
I1 I2 No substitution
effect
B New
Budget
Original Constraint
Budget A=C
Constraint
X1
DECOMPOSITION of TOTAL PRICE EFFECT
PERFECT SUBSTITUTES
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