Income and substitution effects

1. Income and substitution effects

2. Here we want to explore some more of the detail of a price change on the demand for a good. Here is the basic idea. Say the price of x falls. When this happens we think two things are at work: an income effect and a substitution effect. The income effect: If initially we buy the same amount of x as we purchased before, since x has a lower price we will have more of our own income left and so it will feel like we have more income. We saw when we have more income we want more normal and less inferior goods. So, the income effect of a price change means if the price is lowered we could want more or less of the good.

3. The substitution effect: The sub effect is an indication that as the price of a good falls we want more of the good and we use it in substitution for other goods. In economics we like to show the income and substitution effects in the diagram of consumer utility maximization.

4. change in price - optimal point change y Say the consumer starts out at x1, y1. If the price of x should fall the budget line rotates out in a counterclockwise fashion. The dashed line above x1 is similar to the one in the income change diagram. Except here we do not think the consumer y1 x x1 will end up to the left of the dashed line when there is a price decline.

5. change in price - optimal point change The reason we feel the consumer will not end up to the left of the dashed line is twofold: when the price falls 1) at the initial amount of x purchased the consumer feels richer and we saw this may make them buy more or less of x(income effect of a price change), 2) x becomes relatively cheaper and we feel people move toward now relatively cheaper products and away from now relatively more expensive items(substitution effect of a price change).

6. change in price - optimal point change So, the income effect means more or less x given a price decline, and the substitution effect means more x given a price decline. Now if the good is an inferior good 1) the income effect says less x 2) the substitution effect says more x. The only way we could end up to the left of the dashed line on the previous screen is if the income effect operating with an inferior good is larger than the substitution effect. Economists have felt this rarely, if ever, happens – if so we call it a Giffen good.

7. income and substitution effect y Focusing only on good x here, say we start at point r. With a price decline in x this consumer would end up at point t. But I have also shown point s. Here is how to think about this point: after the price fall think about the consumer losing enough income so that the initial utility level could be obtained. x r s t

8. income and substitution effect The movement from r to s highlights the substitution effect because the consumer had the income effect of the price change taken away. The movement from s to t is the income effect.

9. The demand curve P From 2 screens ago we saw a price decline had us move from point r to t. When we put this info into a price, quantity graph we see the demand curve is downward sloping. P1 P2 x (usually we put Q) Q1 Q2 (r t)

10. The demand curve You and I already knew the demand curve was downward sloping, but now we also know it is because we think substitution effects outweigh income effects. Plus we know at each point along the demand curve the consumer is maximizing their utility given the situation they find themselves in. We also know now that at lower prices the consumer reaches a higher level of satisfaction. This was not always obvious along just the demand curve.

11. income and substitution effect y Focusing only on good x here, say we start at point r. With a price increase in x this consumer would end up at point t. But I have also shown point s. Here is how to think about this point: after the price increase think about the consumer getting enough income so that the initial utility level could be obtained. r to s sub effect s to t income effect x t s r

12. To highlight the income and substitution effects of a price change we put in an intermediate point. Essentially what we did was say after the price change let’s show a hypothetical change in income to get the consumer back to the original indifference curve that they started with. (Lower price, take income away, higher price, give income back.) The movement along the original indifference curve is then the substitution effect. Then take the income change back out to see the income effect.