INCOME AND SUBSTITUTION

EFFECTS

Copyright ©2005 by South-Western, a division of Thomson Learning. All rights reserved. 1

 Demand Functions
• The optimal levels of x1,x2,…,xn can be
expressed as functions of all prices and
income
• These can be expressed as n demand
functions of the form:
x1* = d1(p1,p2,…,pn,I)
x2* = d2(p1,p2,…,pn,I)
•
•
•
xn* = dn(p1,p2,…,pn,I)
2
 Demand Functions
• If there are only two goods (x and y), we
can simplify the notation
x* = x(px,py,I)
y* = y(px,py,I)
• Prices and income are exogenous
– the individual has no control over these
parameters

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 Homogeneity
• If we were to double all prices and
income, the optimal quantities demanded
will not change
– the budget constraint is unchanged
xi* = di(p1,p2,…,pn,I) = di(tp1,tp2,…,tpn,tI)
• Individual demand functions are
homogeneous of degree zero in all prices
and income
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 Homogeneity
the demand functions

0 .3 I 0 .7 I
x*  y* 
px py

• Note that a doubling of both prices and

income would leave x* and y*
unaffected
5
 Increase in Income
• If both x and y increase as income rises,
x and y are normal goods

Quantity of y
As income rises, the individual chooses
to consume more x and y

C
B

A U3
U2
U1
Quantity of x
6
 Increase in Income
• If x decreases as income rises, x is an
inferior good
As income rises, the individual chooses
to consume less x and more y
Quantity of y

B U3

U2
A
U1
Quantity of x
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 Normal and Inferior Goods
• A good xi for which xi/I  0 over some
range of income is a normal good in that
range

• A good xi for which xi/I < 0 over some

range of income is an inferior good in
that range

8
 Changes in a Good’s Price
When the price changes, two effects
come into play
– substitution effect
– income effect

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 Changes in a Good’s Price
• Even if the individual remained on the same
indifference curve when the price changes,
his optimal choice will change because the
MRS must equal the new price ratio
– the substitution effect
• The price change alters the individual’s
“real” income and therefore he must move
to a new indifference curve
– the income effect
10
 Changes in a Good’s Price
Suppose the consumer is maximizing
Quantity of y
utility at point A.

If the price of good x falls, the consumer

will maximize utility at point B.
B

A
U2

U1

Quantity of x
Total increase in x
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 Changes in a Good’s Price
Quantity of y To isolate the substitution effect, we hold
“real” income constant but allow the
relative price of good x to change
The substitution effect is the movement
from point A to point C

A C The individual substitutes

good x for good y
because it is now
U1
relatively cheaper
Quantity of x

Substitution effect
12
 Changes in a Good’s Price
Quantity of y The income effect occurs because the
individual’s “real” income changes when
the price of good x changes
The income effect is the movement
from point C to point B
B
If x is a normal good,
A C
U2 the individual will buy
more because “real”
U1
income increased
Quantity of x

Income effect

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 Changes in a Good’s Price
Quantity of y
An increase in the price of good x means that
the budget constraint gets steeper
The substitution effect is the
C
movement from point A to point C
A
The income effect is the
B
U1 movement from point C
to point B
U2

Quantity of x
Substitution effect
Income effect
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 Price Changes for
Normal Goods
• If a good is normal, substitution and
income effects reinforce one another
– when price falls, both effects lead to a rise in
quantity demanded
– when price rises, both effects lead to a drop
in quantity demanded

15
 Price Changes for
Inferior Goods
• If a good is inferior, substitution and
income effects move in opposite directions
• The combined effect is indeterminate
– when price rises, the substitution effect leads
to a drop in quantity demanded, but the
income effect is opposite

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 FIGURE 3.5: Income and Substitution
Effects for an Inferior Good
Quantity of Y
per week

Y*
U2
Old budget constraint

0 Quantity of X
Copyright (c) 2000 by
X*
per week
Harcourt, Inc. All
 FIGURE 3.5: Income and Substitution
Effects for an Inferior Good
Quantity of Y
per week

New budget constraint

Y*
U2
Y**
Old budget constraint

U1
0 Quantity of X
Copyright (c) 2000 by
X*
per week
Harcourt, Inc. All
 FIGURE 3.5: Income and Substitution
Effects for an Inferior Good
Quantity of Y
per week

New budget constraint

Y*
U2
Y**
Old budget constraint

U1
0 Quantity of X
Copyright (c) 2000 by
X** X*
per week
Harcourt, Inc. All
 Giffen’s Paradox
• If the income effect of a price change is
strong enough with an inferior good, it is
possible for the quantity demanded to
change in the same direction as the
price change.
• Legend has it that this phenomenon
was observed by English economist
Robert Giffen.
Copyright (c) 2000 by
Harcourt, Inc. All
 A Summary
• Utility maximization implies that (for normal
goods) a fall in price leads to an increase in
quantity demanded
– the substitution effect causes more to be
purchased as the individual moves along an
indifference curve
– the income effect causes more to be purchased
because the resulting rise in purchasing power
allows the individual to move to a higher
indifference curve
21
 A Summary
• Utility maximization implies that (for normal
goods) a rise in price leads to a decline in
quantity demanded
– the substitution effect causes less to be
purchased as the individual moves along an
indifference curve
– the income effect causes less to be purchased
because the resulting drop in purchasing
power moves the individual to a lower
indifference curve 22
 A Summary
• Utility maximization implies that (for inferior
goods) no definite prediction can be made
for changes in price
– the substitution effect and income effect move
in opposite directions
– if the income effect outweighs the substitution
effect, we have a case of Giffen’s paradox

23
The Individual’s Demand Curve
• An individual’s demand for x depends
on preferences, all prices, and income:
x* = x(px,py,I)
• It may be convenient to graph the
individual’s demand for x assuming that
income and the price of y (py) are held
constant

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 The Individual’s Demand Curve
Quantity of y As the price px
of x falls...
…quantity of x
demanded rises.
px’

px’’

px’’’

U3
U2 x
U1

x1 x2 x3 x’ x’’ x’’’
Quantity of x Quantity of x
I = px’ + py I = px’’ + py I = px’’’ + py 25
The Individual’s Demand Curve
• An individual demand curve shows the
relationship between the price of a good
and the quantity of that good purchased by
an individual assuming that all other
determinants of demand are held constant

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 Shifts in the Demand Curve
• Three factors are held constant when a
demand curve is derived
– income
– prices of other goods (py)
– the individual’s preferences
• If any of these factors change, the
demand curve will shift to a new position

27
 Shifts in the Demand Curve
• A movement along a given demand
curve is caused by a change in the price
of the good
– a change in quantity demanded
• A shift in the demand curve is caused by
changes in income, prices of other
goods, or preferences
– a change in demand
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