Lecture7
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The document discusses the decomposition of the total price effect of a good into substitution and income effects. It explains: 1) The substitution effect captures how consumers change their consumption in response to relative price changes, keeping purchasing power constant. The income effect is due to changes in real income from the price change. 2) Both the Hicksian and Slutsky methods are presented to isolate the substitution and income effects. The Hicksian method involves moving along and between indifference curves. The Slutsky method adjusts income to keep purchasing power constant. 3) For normal goods, the substitution and income effects reinforce each other when the good's own price falls. For inferior goods, they may oppose each
Lecture7
- 1. Price Change: Income and Substitution Effects
- 2. THE IMPACT OF A PRICE CHANGE Economists often separate the impact of a price change into two components: –the substitution effect; and –the income effect.
- 3. 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 results from 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.
- 4. 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 are two main methods: (i) The Hicksian method; and (ii) The Slutsky method
- 5. THE HICKSIAN METHOD Sir John R.Hicks (1904-1989) Awarded the Nobel Laureate in Economics (with Kenneth J. Arrrow) in 1972 for work on general equilibrium theory and welfare economics.
- 6. THE HICKSIAN METHOD X2 X1 Ea I1 xa Optimal bundle is Ea, on indifference curve I1.
- 7. THE HICKSIAN METHOD X2 X1 I1 xa Ea A fall in the price of X1 The budget line pivots out from PP*
- 8. THE HICKSIAN METHOD X2 X1 Eb I1 I2 xa xb Ea The new optimum is Eb on I2. The Total Price Effect is xa to xb
- 9. THE HICKSIAN METHOD To isolate the substitution effect we ask…. “what would the consumer’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)
- 10. THE HICKSIAN METHOD X2 X1 Eb I1 I2 xa xb Ea The new optimum is Eb on I2. The Total Price Effect is xa to xb
- 11. THE HICKSIAN METHOD X2 X1 I1 I2 xa xb Ea Eb Draw a line parallel to the new budget line and tangent to the old indifference curve
- 12. THE HICKSIAN METHOD X2 X1 Ec I1 I2 xa xc xb Ea Eb The new optimum on I1 is 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 relative prices
- 13. THE HICKSIAN METHOD X2 X1 I1 I2 Substitution Effect Ea Eb Ec This is the substitution effect. Xa Xc
- 14. 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.
- 15. THE HICKSIAN METHOD X2 X1 I1 I2 Income Effect Ea Eb Ec The remainder of the total effect is due to a change in real income. The increase in real income is evidenced by the movement from I1 to I2 Xc Xb
- 16. THE HICKSIAN METHOD X2 X1 I1 I2 xa xc xb Sub Effect Income Effect Ea Eb Ec
- 17. HICKSIAN ANALYSIS and DEMAND CURVES 22111 xpxpM += P1 P1* 22111 xpxpM += ∗ A A B B C Hicksian Demand Curve (A & C) Marshallian Demand Curve (A & B) P X1 X1 P A fall in price from p1 to p1 * C
- 18. HICKSIAN ANALYSIS and DEMAND CURVES Hicksian (compensated) demand curves cannot be upward-sloping (i.e. substitution effect cannot be positive)
- 19. 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” he introduced “Slutsky Decomposition”.
- 20. THE SLUTSKY METHOD X2 X1 Ea I1 xa Optimal bundle is Ea, on indifference curve I1.
- 21. THE SLUTSKY METHOD X2 X1 I1 xa Ea A fall in the price of X1 The budget line pivots out from PP*
- 22. THE SLUTSKY METHOD X2 X1 Eb I1 I2 xa xb Ea The new optimum is Eb on I2. The Total Price Effect is xa to xb
- 23. 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, at the new prices, s/he can just afford to buy the original bundle?”
- 24. THE SLUTSKY METHOD To isolate the substitution effect we adjust the 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.
- 25. THE SLUTSKY METHOD X2 X1 Eb I1 I2 xa xb Ea The new optimum is Eb on I2. The Total Price Effect is xa to xb
- 26. THE SLUTSKY METHOD X2 X1 Eb I1 I2 xa xb Ea Draw a line parallel to the new budget line which passes through the point Ea.
- 27. THE SLUTSKY METHOD X2 X1 Eb I3 I2 xa xb Ea The new optimum on I3 is at Ec. The movement from Ea to Ec is the substitution effect Ec xc
- 28. THE SLUTSKY METHOD X2 X1 Eb I3 I2 xa Ea The new optimum on I3 is at Ec. The movement from Ea to Ec is the substitution effect Ec xc Substitution Effect
- 29. THE SLUTSKY METHOD X2 X1 Eb I3 I2Ea The remainder of the total price effect is the Income Effect. The movement from Ec to Eb. Ec xc Income Effect xb
- 30. THE SLUTSKY METHOD for NORMAL GOODS Most goods are normal (i.e. demand increases with income). The substitution and income effects reinforce each other when a normal good’s own price changes.
- 31. THE SLUTSKY METHOD for NORMAL GOODS X2 X1 Eb I3 I2Ea The income and substitution effects reinforce each other. Ec xc xbxa
- 32. 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 METHOD for NORMAL GOODS
- 33. THE SLUTSKY EQUATION Let be the original budget constraint and let 22111 xpxpM += 22112 xpxpM += ∗ represent the budget constraint after the Slutsky compensating variation in income has been carried out.
- 34. THE SLUTSKY EQUATION X2 X1 Ea xa 22111 xpxpM += 22112 xpxpM += ∗ Demand for x1 is ( )Mppxx d ,, 211 = M2 < M1
- 35. THE SLUTSKY EQUATION M2 - M1 ( ) ( ) ( ) ( ) 11111 11112 111112 2211221112 2211221112 - -M -M -M -M pppaspxM ppxMM xpxpMM xpxpxpxpMM xpxpxpxpMM ∆=∆=∆ =−=∆ =−=∆ −+=−=∆ ++=−=∆ ∗ ∗ ∗ ∗ ∗ ∆M=x1∆p1 gives the change in money income needed to consume the original bundle of goods (at EA)
- 36. THE SLUTSKY EQUATION ( ) ( )1211211 ,,,, MppxMppxx dd −=∆ ∗ The demand curve holding M constant is given by which is the change in demand for x1 due to the change in its own price, holding M and the price of x2 constant (1)
- 37. THE SLUTSKY EQUATION ( ) ( ),,,, 121221 MppxMppxx dd s −=∆ ∗ The change in demand due to the Slutsky substitution effect is given by (3) ( ) ( ),,,, 221121 MppxMppxx dd m ∗∗ −=∆ The income effect is given by (2)
- 38. THE SLUTSKY EQUATION ( ) ( )121221 ,,,, MppxMppxx dd s −=∆ ∗ ( ) ( )221121 ,,,, MppxMppxx dd m ∗∗ −=∆ ( ) ( )1211211 ,,,, MppxMppxx dd −=∆ ∗ ms xxx ∆+∆=∆ 1 Given Claim Show this by substituting equations (1), (2) and (3) into equation (4) (1) (2) (4) (3)
- 39. THE SLUTSKY EQUATION ms xxx ∆+∆=∆ 1 Divide across by ∆p1 111 1 p x p x p x ms ∆ ∆ + ∆ ∆ = ∆ ∆ Recall 11 pxM ∆=∆ so 11 )( xMp ∆−=∆
- 40. THE SLUTSKY EQUATION Substituting 11 )( xMp ∆−=∆ 111 1 p x p x p x ms ∆ ∆ + ∆ ∆ = ∆ ∆ Gives 1 11 1 x M x p x p x ms ∆ ∆ − ∆ ∆ = ∆ ∆ THE SLUTSKY EQUATION
- 41. THE SLUTSKY METHOD: INFERIOR GOODS Some goods are (sometimes) inferior (i.e. demand is reduced by higher income). The substitution and income effects “oppose” each other when an inferior good’s own price changes.
- 42. THE SLUTSKY METHOD: INFERIOR GOODS X2 X1 Eb I3 I2 Ea The substitution effect is as per usual. But, the income effect is in the opposite direction. Ec xcxbxa xa to xc xc to xb
- 43. 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.
- 44. THE SLUTSKY METHOD for INFERIOR GOODS X2 X1 Eb I3 I2 Ea In rare cases of extreme income- inferiority, the income effect may be larger in size than the substitution effect, causing quantity demanded to fall as own-price falls.Ec xb xcxa xa to xc xc to xb
- 45. 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.
- 46. DECOMPOSITION of TOTAL PRICE EFFECT: PERFECT COMPLEMENTS I1 I2 No substitution effect X2 X1 A=C B Original Budget Constraint New Budget Constraint A fall in the price of X1
- 47. DECOMPOSITION of TOTAL PRICE EFFECT PERFECT SUBSTITUTES ?