Consumer Behavior (II):

Income and Substitution Effects

Dr. Manuel Salas-Velasco

University of Granada, Spain

1
 Consumer Behavior (II)

Introduction

Dr. Manuel Salas-Velasco 2

 The Budget Constraint

vertical The equation for

M
intercept the budget line:
PY
M PX
Y 
Quantity of Y

X
PY PY

Slope
Budget set
Relative price ratio
The budget set PX

consists of all PY
bundles that are
affordable at the Quantity of X M
given prices and PX
income
horizontal intercept
Dr. Manuel Salas-Velasco 3
 The Consumer’s Utility Maximizing Choice

• The consumer’s utility is

Quantity of Y
maximized at the point (E)
where an indifference
curve is tangent to the
budget line
• The condition for utility E
Y*
maximization

MU X MU Y

PX PY

(X*, Y*) is the utility-maximizing bundle

X* Quantity of X
• The optimum quantities (X*, Y*) obtained by solving the Lagrangean problem tell
us how much of each good an individual consumer will demand, assuming that
he/she behaves rationally and optimizes his/her utility within his/her budget.
Dr. Manuel Salas-Velasco 4
 Consumer Behavior (II)

The Consumer’s Reaction to a Change in

Income

Dr. Manuel Salas-Velasco 5

 Shifts in the Budget Line
M PX 25
Y  X
PY PY
M
12 20
Quantity of lemonade (week), Y

PY
10

8 15
6
M
4 10
PY
2

0 5
0 1 2 3 4 5
Quantity of ice-cream (week), X 0

M = 10; PX = 2; PY = 1 Y  10  2 X 0 1 2 3 4 5 6 7 8 9 10
M M
Prices are held constant and M’ = 20; PX = 2; PY = 1 PX PX
income increases (e.g. the
consumer’s income doubles) M’ > M Y  20 - 2 X
Dr. Manuel Salas-Velasco 6
 Response to Income Changes
• Increases in money
Prices are held constant PX , PY income cause a parallel
Income increases: M1 < M2 < M3 outward shift of the budget
line
Y • The utility-maximizing
M3 Income-Consumption Curve point moves from E1 to E2
PY to E3
M2
PY
• By joining all the
E3 utility-maximizing points,
M1 Y3*
U3 an income-consumption
PY
Y2* E2 line is traced out
U2
Y1
*
E1
U1 X, Y, normal goods

M1 M2 M3
X
* * *
X X
1 2 X 3
Dr. Manuel Salas-Velasco
PX PX PX 7
 How Consumption Changes as Income
Changes

Y  Y PX , PY ,M 
Y
Engel Curve

for good Y, with

good Y as normal

Y3*
Y2*

Y1*

M
M1 M2 M3

Dr. Manuel Salas-Velasco 8

 Engel Curve or Engel’s Law

 A general reference to the

function which shows the
relationship between
various quantities of a good
a consumer is willing to
purchase at varying income
levels (ceteris paribus)
Ernst Engel
(1821-1896)
 A German statistician who
studied the spending patterns
of groups of people of different
incomes
 People spent a smaller and
smaller proportion of their
incomes on food as those
incomes increased

Dr. Manuel Salas-Velasco 9

 Consumer Behavior (II)

The Consumer’s Reaction to a Change in

Price

Dr. Manuel Salas-Velasco 10

 Shifts in the Budget Line
M PX
Y  X
PY PY 12
12
Quantity of lemonade (week), Y

M 10
10
PY
8
8
6
4 6
2
4
0
0 1 2 3 4 5
2
Quantity of ice-cream (week), X

0
M = 10; PX = 2; PY = 1
0 1 2 3 4 5 6 7 8 9 10
M M
Y  10  2 X
PX PX

Decrease in the price of X (50%) M = 10; P’X = 1; PY = 1 Y  10 - X

Dr. Manuel Salas-Velasco 11
 Response to Changes in a Good’s Price
Price of Y and income are held constant: PY , M

Decrease in the price of X: PX1 > PX2 > PX3

Y
M
PY

E1 Price-Consumption
Y1*
E2 Curve
Y2*
Y3* E3
U2 U3
U1

X
X *
1 X M
*
2 X *
3
M M
Dr. Manuel Salas-Velasco PX1 PX2 PX3 12
 How Consumption Changes as Price Ratio
Changes

Price
of X

PX1
PX2
PX3 Demand Curve for X

Quantity, X

X 1* X 2* X 3*
Dr. Manuel Salas-Velasco 13
 The Consumer’s Demand Function
• We are interested in finding the individual demand curve
for the good X; an expression for quantity demanded as a
function of all prices and income

• Let’s suppose that the utility function is: U = X Y + X + Y

MU X MU Y
• The condition for utility maximization is: 
PX PY

U = U (X, Y)
U
MU X  MU X  Y  1
X
Y 1 X 1

U PX PY
MU Y  MU Y  X  1
Y
PX
Y  (X  1) 1
PY

Dr. Manuel Salas-Velasco 14

 The Consumer’s Demand Function
PX
Y  (X  1) 1
PY

 P 
PX X + PY Y = M PX X  PY  (X  1) X  1  M
 PY 

PX X  (X  1) PX  PY  M PX X  PX X  PX  PY  M

2 PX X  M  PX  PY

M  PX  PY
X
2 PX

Consumer’s demand function

X = X (PX, PY, M) (generalized demand function)

Dr. Manuel Salas-Velasco 15

 The Own-Price Demand
X  X (PX , PY ,M )

Consumer’s demand function

M  PX  PY
X
2 PX

Suppose we use the following parametric values:

M = $100; PY = $10 X  X (PX , PY ,M )

The own-price demand curve
(ordinary demand function for X):
100  PX  10 110  PX X = f (PX), ceteris paribus
X X
2 PX 2 PX

PX
55
PX 
• However, economists by convention always 0.5  X
graph the demand function with price on the
vertical axis and quantity demanded on the The inverse demand
function
horizontal axis
X
Dr. Manuel Salas-Velasco 16
 The Engel Curve
X  X (PX , PY ,M ) M  PX  PY Consumer’s demand function
X
2 PX

Suppose we use the following parametric values:

PX = $5; PY = $10
X  X (PX , PY ,M)

M  5  10 M 5 M 1 The Engel curve for X

X X X 
25 10 10 2

X M If Income Elasticity is positive, then X is a

Income elasticity  normal good
M X
(quantity demanded increases as income
increases, ceteris paribus)

X  X is a normal

1
 positive Income elasticity    positive
M 10  good

Dr. Manuel Salas-Velasco 17

 The Cross-Price Demand Curve
M  PX  PY
X  X (PX , PY ,M ) X Consumer’s demand function
2 PX
Suppose we use the following parametric values:
PX = $5; M = $100 • We hold the own price of good X and money income
constant; we focus on the relationship between the
quantity demanded of good X and the price of good Y

X  X (PX , PY ,M )
Cross-price
100  5  PY 95  PY PY demand curve
X X X  9.5 
25 10 10 for X

 X PY If CPE is positive, then X,Y are substitutes

Cross - price elasticity 
PY X If CPE is negative, then X,Y are complements

X 1  X is a
 ( positive) Cross - price elasticity    positive substitute for Y
PY 10 
Dr. Manuel Salas-Velasco 18
 Cobb-Douglas Utility Function
1 1
• The utility function is: U  X 2 Y 2
MU X MU Y
• The condition for utility maximization is: 
PX PY

U = U (X, Y)
U
MU X  MU X  Y 2
1
1
X
 12
X 2
1
1  12 1
1  12 1 1
Y2 X X2 Y PY X 2 12 Y 2
U
2
 2
 1
PX Y 2 12 X  2
1
MU Y  MUY  X
1
2 1
Y
 12 PX PY
Y 2
PY X PX
 YX
PX Y PY
M
PX X + P Y Y = M
P
PX X  PY X X  M 2PX X  M X 
PY 2 PX
Consumer’s demand
800
PX = 4; M = 800; PY = 1 X  100 function for X
8
X* = 100 units
Dr. Manuel Salas-Velasco 19
 Consumer Behavior (II)

Income and Substitution Effects

Dr. Manuel Salas-Velasco 20

 The Income Effect and the Substitution Effect
of a Price Change
• When price of good X falls, the
optimal consumption level (or
quantity demanded) of good X
increases
• What are the underlying reasons
for a response in the quantity
demanded of good X due to a
change in its own price?
• Substitution effect: the impact
that a change in the price of a
Price good has on the quantity
of X demanded of that good, which is
due to the resulting change in
PX1 relative prices (PX/PY)
PX2 • Income effect: the impact that
Own-Price Demand
PX3 a change in the price of a good has
Curve for X
(Inverse Ordinary on the quantity demanded of that
Total effect Demand Function for X) good due strictly to the resulting
change in real income (or
Quantity, X purchasing power)
X 1* X 2* X 3*
Dr. Manuel Salas-Velasco 21
 Income and Substitution Effects
Price of Y and monetary income are held
Y constant: PY , M total effect (TE) =
substitution effect (SE) +
M Decrease in the price of X: PX1 > PX2
PY
income effect (IE)
PX2
PX1 PY
PY

Y1* E1
* E2
Y 2
U2
U1

M M
PX1 PX2 X
X *
1 SE IE X *
2
TE
Dr. Manuel Salas-Velasco 22
 The Substitution Effect: Two Definitions in
the Literature

The Slutsky substitution effect

The effect on consumer choice of

changing the price ratio, leaving
the consumer just able to afford
his/her initial bundle
Eugene Slutsky
1880-1948

The Hicks substitution effect

The effect on consumer choice of

changing the price ratio, leaving Sir John R. Hicks
his/her initial utility unchanged 1904-89

Dr. Manuel Salas-Velasco 23

 The Slutsky Substitution Effect
Price of Y and monetary income are held
• To remove the income effect, imagine
Y constant: PY , M reducing the consumer’s money income
until the initial bundle is just attainable
M A Decrease in the price of X: PX1 > PX2
PY • We do this by shifting the line AB to a
PX2
parallel line CD that just passes through
PX1 PY
E1 (keeping purchasing power constant)
PY
M • Although X1* , Y1*  is still affordable, it
C is not the optimal purchase at the
PY
budget line CD
• The optimal bundle of goods is:
Y * E1
1 E2
Y2* * E3
Y3
U3 U2
U1
PX2
PY
SE IE
D B X
X *
X * M X * M M
1 3
PX1 TE 2
PX2 PX2
Dr. Manuel Salas-Velasco X is a normal good 24
 The Slutsky Substitution Effect
Y E1: X1* PX1  Y1* PY  M
M’= amount of money income that will just make
M A the original consumption bundle affordable:
PY
PX2 X1* PX2  Y1* PY  M  M  M
1
PX PY
PY M   M  M
M C Change (reduction) in money
PY income necessary to make the
initial bundle affordable at the
new prices
Y1* E1 M  X1* (PX2  PX1 )
* E2
Y 2 E3
Y3* U2
U3 M   M  M
U1 E3:
PX2 X 3* PX2  Y3* PY  M 
PY
SE IE
D B X
X *
X * M X * M M
1 3 2
PX1 TE PX2 PX2
Dr. Manuel Salas-Velasco X is a normal good 25
 Example
M
• The individual demand function for milk is: X  10 
10 PX
• Consumer’s income is $120 per week and PX is $3 per quart:
120
X 1*  10   14 quarts ( week )
10  3
• Let’s suppose that the price of milk falls to $2 per quart:
120
X 2*  10   16 quarts ( week )
10  2
• The total change (total effect): X 2  X1  2
* *

M   M  M M  X1* (PX2  PX1 )  14 (2  3)  14

Level of income necessary to keep purchasing
M   M  M  120  14  $106 power constant
106
X 3*  10   15.3 quarts ( week )
10  2
• The substitution effect is: X 3  X 1  15.3  14  1.3
* *

• The income effect is: 0.7 (16 – 15.3)

Dr. Manuel Salas-Velasco 26
 The Hicks substitution effect
Y PY , M PX1 > PX2 • To remove the income effect, imagine
reducing the consumer’s money income
M A until the initial indifference curve is just
PY attainable
PX2
PX1 PY • We do this by shifting the line AB to a
parallel line CD that just touches the
PY
indifference curve U1 (the utility level is
M C held constant at its initial level)
PY • The intermediate point E3
divides the quantity change
E1 into a substitution effect (SE)
*
Y1* E2 and an income effect (IE)
Y 2 E3
Y3*
U2
U1

PX2
SE IE PY
D B X
*
X X * M X * M M
1 3 2
PX1 TE PX2 PX2
Dr. Manuel Salas-Velasco X is a normal good 27
 Income and Substitution Effects:
Inferior Good
PY , M • The consumer is initially at E1 on budget line AF

Y PX1 > PX2 • With a decrease in the price of good X, the

consumer moves to E2; the quantity of X demanded
increases (total effect)
A
• The total effect can be broken down into:

E2
o A substitution effect (associated with a move
from E1 to E3)
U2
C o An income effect (associated with a move
E1 from E3 to E2)
E3
X is an inferior good
substitution effect
U1

income effect
total effect F D B X
X 1* X 2* X 3*

• The substitution effect exceeds the income effect, so the decrease in the price of
good X leads to an increase in the quantity demanded

Dr. Manuel Salas-Velasco 28

 Income and Substitution Effects:
The Giffen Good
PX1 > PX2 • The consumer is initially at E1 on budget line AF
PY , M
Y • With a decrease in the price of good X, the
consumer moves to E2; the quantity of X demanded
decrease (total effect)
A
• The total effect can be broken down into:
E2
U2 o A substitution effect (associated with a move
from E1 to E3)
C o An income effect (associated with a move
E1 from E3 to E2)
E3
U1
substitution effect
income effect
total effect F D B X
X 2* X 1* X 3*

• The income effect exceeds the substitution effect, X is a Giffen good

so the decrease in the price of good X leads to a
decrease in the quantity demanded
Dr. Manuel Salas-Velasco 29
 Income and Substitution Effects of a reduction in price of good
X holding income and the price of good Y constant

Substitution
Income effect Total effect
Good X is: effect

Increase Increase Increase

Normal

Inferior (not Increase Decrease Increase

Giffen)

Giffen (also Increase Decrease Decrease

inferior)

Dr. Manuel Salas-Velasco 30