THINK LIKE AN ECONOMIST………PMG CLASSES………………….

SAMEER
9810836285

CHAPTER 5

INCOME AND SUBSTITUTION EFFECTS

Problems in this chapter focus on comparative statics analyses of income and

own-price changes. Many of the problems are fairly easy so that students can approach
the ideas involved in shifting budget constraints in simplified settings. Theoretical
material is confined mainly to the Analytical Problems which stress various elasticity
measures and introduce the Almost Ideal Demand System.

Comments on Problems

5.1 An example of perfect substitutes. Solving this is easy with intuition, but
students should not try to use calculus because of the “knife-edge” nature of
demand with perfect substitutes.

5.2 A fixed-proportions example. Illustrates how the goods used in fixed

proportions (peanut butter and jelly) can be treated as a single good looking at
utility maximizing choices.

5.3 An exploration of the notion of homothetic functions. This problem shows that
Giffen's Paradox cannot occur with homothetic functions.

5.4 This problem asks students to pursue the analysis of Example 5.1 to obtain
compensated demand functions. The analysis essentially duplicates Examples
5.3 and 5.4.

5.5 Another utility maximization example. In this case, utility is not separable and
cross-price effects are important.

5.6 This is a problem in revealed preference theory. The bundles here violate the
strong axiom.

5.7 This is a problem with no substitution effects. It shows how price elasticities
are determined only by income effects which in turn depend on income shares.

5.8 This problem shows the convenient result that budget shares can be computed
from expenditure functions through logarithmic differentiation.

Analytical Problems

5.9 Share elasticities. This problem shows that many conventional elasticity
measures can be derived from “share elasticities”. This is useful because many
budgetary studies proceed mainly by focusing on expenditure shares.

MA ECONOMICS ENTRANCE CLASSES BY SAMEER CHAUDHARY Page 26

THINK LIKE AN ECONOMIST………PMG CLASSES…………………. SAMEER
9810836285

5.10 More on elasticities. Shows how the elasticity of substitution affects the sizes
of price elasticities.

5.11 Aggregation of elasticities for many goods. This problem shows how the
aggregation relationships introduced in Chapter 5 for two goods can be
generalized to any number of goods.

5.12 Quasi-linear utility (revisited). This extends Problem 3.13 to consider the
special form of the Slutsky Equation for the Quasi-linear function.

5.13 The almost ideal demand system. This problem introduces a parametrization
of the expenditure function that is widely used in empirical studies of demand.
The connections between this problem and Problem 5.9 are quite important in
the interpretation of many empirical studies.

5.14 Price indifference curves. This problem introduces a graphical concept that is
sometimes used to illustrate theoretical points.

Solutions

5.1 a. Utility = Quantity of water = .75x + 2y.

3
b. If p x < p y x = I p x , y  0.
8

3 I
If p x > py x = 0, y  .
8 py

c.

d. Increases in I shift demand for x outward. Reductions in py do not

8 px
affect demand for x until p y < . Then the demand for x falls to zero.
3

MA ECONOMICS ENTRANCE CLASSES BY SAMEER CHAUDHARY Page 27

THINK LIKE AN ECONOMIST………PMG CLASSES…………………. SAMEER
9810836285

e. The compensated demand curve for good x is a vertical line so long as

px  3 p y / 8 . If the person buys only x, holding utility constant requires
that x  U / 0.75 no matter what the price of x is.

5.2 a. Utility maximization requires pb = 2j and the budget constraint is .05pb

+.1j = 3. Substitution gives pb = 30, j = 15

b. If pj = $.15 substitution now yields j = 12, pb = 24.

c. To continue buying j = 15, pb = 30, David would need to buy 3 more

ounces of jelly and 6 more ounces of peanut butter. This would require
an increase in income of: 3(.15) + 6(.05) = .75.

d.

e. Since David N. uses only peanut better and jelly to make sandwiches (in
fixed proportions), and because bread is free, it is just as though he buys
the good ‘sandwiches’, where psandwich = 2ppb + pj.
In part a, ps = .20, qs = 15;
In part b, ps = .25, qs = 12;
In general,
3 so the demand curve for sandwiches is a hyperbola.
qs =
ps

f. There is no substitution effect due to the fixed proportion. A change in

price results in only an income effect.

5.3 a. As income increases, the ratio px p y stays constant, and the utility-
maximization conditions therefore require that MRS stay constant. Thus,
if MRS depends on the ratio y x , this ratio must stay constant as
income increases. Therefore, since income is spent only on these two
goods, both x and y are proportional to income.
x
b. Because of part (a),  0 so Giffen's paradox cannot arise.
I

MA ECONOMICS ENTRANCE CLASSES BY SAMEER CHAUDHARY Page 28

THINK LIKE AN ECONOMIST………PMG CLASSES…………………. SAMEER
9810836285

5.4 a. Since x  0.3I px , y  0.7 I p y ,

U = .3.3 .7 .7 Ipx.3 p y .7 = BIpx.3 p y .7 where B  .30.3.7 0.7
The expenditure function is then E = B 1Up.3x p.7y .
b. The compensated demand function is x c  E p x  0.3B 1Up x0.7 p 0y.7 .

c. It is easiest to show Slutsky Equation in elasticities by just reading

exponents from the various demand functions:
ex , px  1, ex , I  1, ex c , p  .7, s x  0.3
x

Hence ex , px  ex c , p  sx ex , I or  1  0.7  0.3  1

x

5.5 a. Use of the Lagrangian technique yields

y ( x  1)  px py or py y  px x  px

Substitution into the budget constraint provides

I  px I + px
x= y= .
2 px 2py

Hence, changes in py do not affect x, but changes in px do affect y.

(I + p x )2
b. The indirect utility function is V =
4 p x py

and this yields an expenditure function of

E  V 4 px p y  px

c. Clearly the compensated demand function for x depends on py , whereas

the uncompensated function did not. By Shepherd’s Lemma:

E
xc   V 0.5 px0.5 p0.5
y 1 .
px

5.6 Year 2's bundle is revealed preferred to Year 1's since both cost the same in
Year 2's prices. Year 2's bundle is also revealed preferred to Year 3's for the
same reason. But in Year 3, Year 2's bundle costs less than Year 3's but is not
chosen. Hence, these violate the axiom.

5.7 a. Because of the fixed proportions between h and c, we know that the
demand for ham is h  I ( ph  pc ) . Hence

MA ECONOMICS ENTRANCE CLASSES BY SAMEER CHAUDHARY Page 29

THINK LIKE AN ECONOMIST………PMG CLASSES…………………. SAMEER
9810836285

h ph I p ( p  pc )  ph
eh , ph     h h  .
ph h ( ph  pc ) 2
I ( ph  pc )
 pc
Similar algebra shows that eh , pc  . So, if
( ph  pc )
ph  pc , eh, ph  eh, pc  0.5 .

b. With fixed proportions there are no substitution effects. Here the

compensated price elasticities are zero, so the Slutsky equation shows
that
ex, px  0  sx  0.5 .
2 1
c. With ph  2 pc part a shows that eh , ph  , eh , pc  .
3 3

d. If this person consumes only ham and cheese sandwiches, the price
elasticity of demand for those must be -1. Price elasticity for the
components reflects the proportional effect of a change in the price of
the component on the price the whole sandwich. In part a, for example,
a ten percent increase in the price of ham will increase the price of a
sandwich by 5 percent and that will cause quantity demanded to fall by 5
percent.

5.8
d ln E d ln E dE d p x 1 1 p x
    x  x  sx
d ln p x d E dpx d ln p x E 1 / px E

5.9 Share elasticities

 px x I I Ip x I  px x I 2
a. esx ,I    x   ex ,I  1 .
I px x I I2 px x
If, for example ex ,I  1.5, esx ,I  0.5 .

( px x I ) px p x px  x I
b. esx , px    x   ex , px  1
px px x I I x
If, for example, ex , px  0.75, esx , px  0.25 .
c. Because I may be cancelled out of the derivation in part b,
e p x , p x  ex , p x  1 .
x

 ( px x I ) p y p x p y p y I x p y
d. esx , py    x     ex , py .
p y px x I I px x p y x

kp ky p x k 1 k kp ky p x k
e. Use part b: esx , px   px (1  p p ) 
k
.
(1  p ky px k ) 2 1  p ky px k
y x

To simplify algebra, let d  p ky px k

MA ECONOMICS ENTRANCE CLASSES BY SAMEER CHAUDHARY Page 30

THINK LIKE AN ECONOMIST………PMG CLASSES…………………. SAMEER
9810836285

kd kd  1  d
Hence ex , px  esx , px  1 
1  . Now use the Slutsky
1 d 1 d
equation, remembering that ex ,I  1 .
kd  d  1 1 d ( k  1)
ex c , p  ex , p x  s x     (1  s x )(  ) .
x
1 d 1 d 1 d

5.10 More on elasticities

a. ex , px  (1  sx )  sx ey , p y   sx  s y Hence ex , px  ey , p y    1 .

The sum equals -2 (trivially) in the Cobb-Douglas case.

b. Result follows directly from part a. Intuitively, price elasticities are

large
when σ is large (in absolute value) and small when σ is small.

c. A generalization from the multivariable CES function is possible, but the

constraints placed on behavior by this function are probably not tenable.

5.11 Aggregation of elasticities for many goods

a. Because the demand for any good is homogeneous of degree zero, Euler’s
theorem states
n
x x

j 1
pj i  I i  0.
p j I
Multiplication by 1 xi yields the desired result.

b. Part b and c are based on the budget constraint px i

i i I.

Differentiation with respect to I yields:  p x I  1 .

i
i i

Multiplication of each term by xi I xi I yields  s e  1 . i i ,I

i
c. Differentiation of the budget constraint with respect to pj :
p x
i pi xi p j  x j  0 . Multiplication by I j  xi yields
i

s e
i
i i, j  s j .

5.12 Quasi-linear utility (revisited)

a. First we need to find the demand functions for both the goods. This is
done by straightforward Lagrangian optimization to give:
I  px p
x ; y x
px py

MA ECONOMICS ENTRANCE CLASSES BY SAMEER CHAUDHARY Page 31

THINK LIKE AN ECONOMIST………PMG CLASSES…………………. SAMEER
9810836285

Now, we calculate the income effects and elasticities:

x p  I
Income effect for x   x  x 2
I p xx
x I I
Income elasticity for x  e x , I  . 
I x I  p x
y
Income effect for y   y 0
I
y I
Income elasticity for y  e y , I  . 0
I y
b. Now we need to find the compensated demand functions for both the
goods by first finding the indirect utility function. Thus we get:
I  px
V  ln p x  ln p y so the expenditure function is
px
E  px (V  ln px  ln p y  1)
E px
xc   V  ln p x  ln p y ; yc 
p x py
x c 1
Substitution effect for x  
p x p xx
x c p x 1
Compensated own price elasticity for x  e x c , p  . c 
x
p x x ln p x  ln p y  V
y c p
Substitution effect for y    x2
p y py
y c p y
Compensated own price elasticity for y  e y c , p  .  1
y
p y y c

c. For the Slutsky equation, the own price effects of the demand
functions are also needed.
x I y p
 2;   x2
p x px p y py
So, putting all the terms into the Slutsky equation:
x I x c x 1 px  I I x x c x
For x :  2; x    2   x
p x px p x I px 2
px px p x p x I
y p y c y p y y c y
For y :   x2 ; y   x2  0   y
p y py p y I py p y p y I
Thus, the Slutsky equation holds for both goods.
Now, for the elasticity version of the equation, we need the own price
elasticitiy of each good.
I
e x, px  ; e y , p y  1
px  1
Putting all this into the elasticity version of the Slutsky equation:

MA ECONOMICS ENTRANCE CLASSES BY SAMEER CHAUDHARY Page 32

THINK LIKE AN ECONOMIST………PMG CLASSES…………………. SAMEER
9810836285

I
For x : e x , p x  ;
px  I
1  p  I px I
e xc , p - s x ex,I =  1  x   1 
x
ln p x  ln p y  V  I  I  px px  I px  I
 e x, px  e xc , p - s x ex,I
x

For y : e y , p y  1; e y c , p  s y e y , I  1  0  1  e y , p y  e y c , p  s y e y , I
y y

This confirms the elasticity version of the Slutsky equation.

5.13 The almost ideal demand system

a.
1 1
ln E ( p1 , p 2 , u )  a0   1 ln p1   2 ln p 2   11 (ln p1 ) 2   22 (ln p 2 ) 2
2 2
1  2
  12 ln p1 ln p 2  u 0 p1 p 2
b. If the function is homogeneous to degree 1 in p ,
E(kp1 , kp2 , u)  kE( p1 , p2 , u) where k is a scalar.
1 1
ln E (kp1 , kp2 , u )  a 0   1 ln kp1   2 ln kp2   11 (ln kp1 ) 2   22 (ln kp2 ) 2
2 2
1 2
  12 ln kp1 ln kp2  u 0 (kp1 ) (kp2 )
1
 a 0   1 ln k   1 ln p1   2 ln k   2 ln p 2   11 (ln k ) 2   11 ln k log p1
2
1 1 1
  11 (ln p1 ) 2   22 (ln k ) 2   22 ln k ln p 2   22 (ln p 2 ) 2   12 (ln k ) 2
2 2 2
 
  12 ln k log p1   12 ln k log p 2   12 ln p1 log p 2  k ( 1   2 ) u 0 p1 1 p 2 2

Next, we gather together the terms with k in it.

From the constraints, we can see that:
1   2  1;  11   12  0;  21   22  0; 1   2  0

This simplifies the mess to a great extent to give:

1 1
ln E (kp1 , kp2 , u )  ln k  a0   1 ln p1   2 ln p 2   11 (ln p1 ) 2   22 (ln p 2 ) 2
2 2
1  2
  12 log p1 ln p 2  u 0 p1 p 2
 ln k  ln E ( p1 , p 2 , u )  ln kE( p1 , p 2 , u )

Thus, E (kp1 , kp2 , u) = kE( p1 , p2 , u) and so, the function is

homogeneous to degree 1 in prices.

d ln E
c. From Problem 5.8: s x 
d ln px

MA ECONOMICS ENTRANCE CLASSES BY SAMEER CHAUDHARY Page 33

THINK LIKE AN ECONOMIST………PMG CLASSES…………………. SAMEER
9810836285

s1  1   11 ln p1   12 ln p2  u 0 1 p11 p22
Similarly,
s2   2   22 ln p2   12 ln p1  u 0  2 p11 p22

So, neglecting the utility–related terms, the shares are simple functions
of the logarithms of prices.

5.14 Price indifference curves

I2
a. From Example 4.3, V  0.5Ip x0.5 p y 0.5 . Hence p y 
4V 2 p x
b. The slope shows the rate at which the prices should move relative to one
another for the utility to remain constant, given I
( dp y / dpx   I 2 / 4V 2 p x2  0
c. With increasing levels of utility, i.e., with increasing V, the curves move
progressively “inward”, i.e., towards the origin.

MA ECONOMICS ENTRANCE CLASSES BY SAMEER CHAUDHARY Page 34