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
h substitution
b i i effect;
ff andd
– 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
ff results from
f 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
Th are two main
i methods:
h d
(i) The Hicksian method; and
(ii) The Slutsky method
 THE HICKSIAN METHOD
 Sir John R.Hicks (1904-1989)
(1904 1989)
 Awarded the Nobel Laureate in
E
Economicsi (with
( ith Kenneth
K th J.
J Arrrow)
A )
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 ffall
ll in
i the
th price
i off X1
The budget
g line pivots
p
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
“what consumer’s 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 (I1)
 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
Thi i the
th
substitution effect.

Eb
Ea I2
Ec
I1
X1
Xa Substitution
S b tit ti 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 byy the
movement from I1 to I2
Eb
Ea I2
Ec
I1
X1
Xc Income Effect
ff Xb
 THE HICKSIAN METHOD
X2

Eb
Ea I2
Ec
I1
xa xc xb X1
Sub
S b Income
I
Effect Effect
 HICKSIAN ANALYSIS and DEMAND CURVES
P
A fall in price
M1  p1 x1  p2 x2
from p1 to p1*

B
AC
M1  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
upward-sloping
sloping
(i.e. substitution effect cannot be
positive)
 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”
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 ffall
ll in
i the
th price
i off X1
The budget
g line pivots
p
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,
th t att the
th new prices,
i s/he
/h can just
j t
afford to buy the original bundle?”
 THE SLUTSKY METHOD
 To isolate the substitution effect we
adjust the consumer’s
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
Ea.
Eb
Ea I2

I1
xa xb X1
 THE SLUTSKY METHOD
The new optimum
X2 on I3 is
i att Ec.
E The
Th
movement from Ea
t E
to Ec iis the
th
substitution effect

Eb
Ea I2
Ec
I3
xa xc xb X1
 THE SLUTSKY METHOD
The new optimum
X2 on I3 is
i att Ec.
E The
Th
movement from Ea
t E
to Ec iis the
th
substitution effect

Eb
Ea I2
Ec
I3
xa xc X1
Substitution Effect
 THE SLUTSKY METHOD
The remainder of
X2 th total
the t t l price
i effect
ff t
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).
income)
 The substitution and income effects
reinforce
i f each
h other
h when
h a normall
good’s own price changes.
g g
 THE SLUTSKY METHOD for
NORMAL GOODS
The income and
X2 substitution
b tit ti effects
ff t
reinforce each
other.
th

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
Q
Let M 1  p1 x 1  p 2 x 2

be the original budget constraint

and let
M 2  p 1 x 1  p 2 x 2

represent the budget constraint after the

Slutsky compensating variation in income
has been carried out.
 THE S
SLUTSKY
U S EQUATION
QU ON
Demand for x1 is
X2 M2 < M1
x1  x  p1, p2 , M 
d

M1  p1 x1  p2 x2
Ea

xa
X1
M2  p1x1  p2 x2
 THE SLUTSKY EQUATION
M2 - M1
M  M 2  M 1   
p1 x1 
 p2 x2 -  p1 x1  p2 x2 

M  M 2  M 1  p1 x1  p2 x2 - p1 x1  p2 x2

M  M 2  M 1  p1 x1 - p1 x1
M  M 2  M 1  
x1 p1  - p1 
M  x1p1 as  
p1 
- p1  p1
gives
i the
th change
h in
i money

M=x1p
income needed to
consume the original p1
bundle of goods (at EA)
 THE S
SLUTSKY
U S EQUATION
QU ON
The demand curve holding
gM
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
Q

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  p , M  x  p , p , M 
d 
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
Q

x1  x s  x m
Divide across by p1

x1 x s x m
 
p1 p1 p1
Recall M  x1p1

so p1  () M x1
 THE SLUTSKY EQUATION
Q
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
(i.e.
income).
 The
Th substitution
b i i and d income
i effects
ff
“oppose” each other when an
inferior good’s own price changes.
 THE SLUTSKY METHOD: INFERIOR
GOODS
The substitution
X2 effect
ff t iis as per
usual. But, the
i
income effect
ff t is
i
in the opposite
Eb di
direction.
ti
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.
goods
 THE SLUTSKY METHOD for
INFERIOR GOODS
In rare cases of
X2 extreme
t iincome-
inferiority, the income
effect may be larger
Eb in size than the
I2 substitution effect,
effect
causing quantity
Ea demanded
de a ded to falla 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
?