Income and Substitution Effect

10 Key excerpts on "Income and Substitution Effect"

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  The Economic Organization of the Household

  • W. Keith Bryant, Cathleen D. Zick(Authors)
  • 2005(Publication Date)
  • Cambridge University Press

    (Publisher)

  Consequently, it will buy more of X and less of “all other goods.” Definition : The substitution effect of a price change is the effect of a change in a good’s price on the demand for that good, holding satisfaction constant. The income effect is quite simple. The decrease in the price of X opens up consumption alternatives not available at the old price. This is exactly what an increase in real income does, and the household responds in the same manner: by increasing its consumption of both X and “all other goods” (so long as both are normal goods). Definition : The income effect of a price change is the effect on the demand for X of the change in “income” brought about by the change in the price of X . The Geometry of Income and Substitution Effects Figure 3.7 illustrates the geometry of Income and Substitution Effects. The household’s pre-price-change budget line is AC , and given its preferences, its equilibrium purchase pattern of X and “all other goods” is E 0 . Now suppose p x falls, the new budget line being AC 1 . The postchange demand for X is q 1 x , so that the own-price effect is q 1 x − q 0 x . Now suppose, instead, that at the same time p x fell, sufficient income was (hypothetically) taken away from the household so that it was no better and no worse off at the new, lower price of X than it was before the price fell. If the household is no better and no worse off at the new relative price of X than it was at the old relative price, it must be on the same indifference curve. If the household faces the new price of X rather than the old, and if it is no better off than before, its budget line must be tangent to the same indifference curve it was on before the price fell and some of its income had been taken away. This budget line is A C in Figure 3.7 . It has been drawn parallel to AC 1 , reflecting the new relative 54 The Economic Organization of the Household Figure 3.7.

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  Intermediate Microeconomics with Microsoft Excel

  • Humberto Barreto(Author)
  • 2009(Publication Date)
  • Cambridge University Press

    (Publisher)

  Income and Substitution Effects explain how this total effect came to be by decomposing the total effect into two parts that add up to the total. 144 Income and Substitution Effects with Quasilinear Preferences 145 U = 15.25 U = 22.875 U = 7.625 0 5 10 15 20 25 0 25 50 75 100 x1 x2 Figure 1.4.7.1. Initial optimal solution. Source: IncSubEffectsPractice!OptimalChoice The substitution effect tells us how much less the consumer would have purchased when price rises strictly from the fact that the relative prices of the two goods have changed. We compute how much income we have to give the consumer to cancel out the reduced purchasing power caused by the price increase to focus exclusively on the relative price change. Figure 1.4.7.2 shows this manipulation with indifference curves suppressed to highlight the budget lines under consideration. From point A, price rose and the consumer will now be at point C on the new budget line (labeled p 1 ↑ ). The dashed line is the result of a hypothetical scenario in which the consumer has been given enough income to purchase the initial bundle A. Notice how the original budget line and the dashed line go through point A. The dashed line has a higher price, but also a higher income. Thus, the move-ment from point A to point B reflects solely the different relative prices in the goods, without any change in purchasing power. This is the substitution effect. While the substitution effect is focused on relative prices, the income effect is that part of the response in quantity demanded when price changes that is due to changed purchasing power. From point B, a decrease in income from the dashed to the new budget line leads to a decrease in x 1 (at point C). Thus, x 1 is a normal good from point B to C and the two effects are working in tandem. The demand curve is guaranteed to be downward sloping for this price change. x1 x2 A p1 p1 m B SE p1 C IE TE Figure 1.4.7.2. The substitution effect.

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  Intermediate Microeconomics

  • John H Hoag(Author)
  • 2012(Publication Date)
  • WSPC

    (Publisher)

  What we want to do is to somehow separate the two forces that are causing demand to have a negative slope. One of the reasons has to do with income apparently changing. We might say that real income changed even though money income did not. What we need is a definition of real income that will allow us to know when it is changing and when it is not. On the one hand, we could use some kind of price index as we do in macro. But a more fruitful way to proceed is to think that as long as the well-being of the consumer does not change, the consumer’s real income has not changed. We measure well-being by utility, so if utility does not change, real income does not change.

  Definition 3.2: We say that two bundles represent the same real income if they are on the same indifference curve, have the same utility.

  Substitution occurs when the price of one good changes relative to the price of another good. Hence, the impulse to substitute must be related to how expensive one good is compared to another.

  Definition 3.3: We say that the ratio of relative prices (the relative price ratio or relative prices) is the ratio of the price of X to the price of , Px /Py .

  Exercise 1.  Where do you see the relative price ratio in the consumer’s problem? Be specific!

  We can now state the definitions of the two effects we described above.

  Definition 3.4: The income effect is that part of the movement along demand due to a change in real income with relative prices held fixed. We denote the income effect as .

  Note that in the denominator of the income effect, we have , not represents a change in real income, the indifference curve, not a change in money income, M.

  We are now ready for the remaining effect, the one due to substitution.

  Definition 3.5: The substitution effect is that part of the movement along demand due to a change in relative prices with real income held fixed. We denote the substitution effect as .

  The question is, how can we find these effects? Let us go back to the original derivation of demand. Look again at Figure 3.1 . The initial utility maximization point is at W when the price of X is P

  x

  . When the price of X falls to , the new utility maximization point is at V. How are the real income and relative prices different at V compared to W?

  At W, the relative prices are Px /Py. At V, the relative prices are . What about the real income? We are using the indifference curve to measure real income, so the real income at W is I1 , and at V real income is I2

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  A Short Course in Intermediate Microeconomics with Calculus

  • Roberto Serrano, Allan M. Feldman(Authors)
  • 2018(Publication Date)
  • Cambridge University Press

    (Publisher)

  The Hicks substitution effect, based on the old indifference curve 60 4 Demand Functions and the new price ratio, is the move from x to z . The slightly different substitution effect, developed by Nicholas Kaldor (1908–1986), is based on the new indifference curve, and a hypothetical budget line whose slope is given by the old price ratio. The Kaldor substitution effect is the shift from w to y . Which one is right? Why they both are, even though they give slightly different measurements! It’s easy to see in any of the substitution effect/income effect figures that the substitution effect is always negative (or at least less than or equal to 0). That is, as price goes down, quantity demanded via the substitution effect goes up, and as price goes up, quantity demanded via the substitution effect goes down. The income effect, however, can have either sign. If the good is normal, the income effect is negative. That is, as price goes down, quantity demanded via the income effect goes up. On the other hand, if the good is inferior, the income effect is positive. That is, as price goes down, quantity demanded via the income effect goes down. In short, for a normal good, the Income and Substitution Effects work in the same direction. As price goes down, both say: consume more. But for an inferior good, the substitution effect and the income effect work in opposite directions. As price goes down, the substitution effect says: consume more. The income effect says: consume less. The net effect is then ambiguous, and if the income effect (consume less) outweighs the substitution effect (consume more), we have a Giffen good. An exercise at the end of this chapter invites the reader to construct a Hicks-style substitution effect/income effect picture of a Giffen good. 4.6 The Compensated Demand Curve In Section 4.3 , we discussed demand curves. Recall that, in the abstract, demand for good 1 is a function x 1 ( p 1 , p 2 , M ) of three variables.

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  Microeconomics

  Theory and Applications

  • Edgar K. Browning, Mark A. Zupan(Authors)
  • 2019(Publication Date)
  • Wiley

    (Publisher)

  When the price falls to $1 per pound, the budget line pivots out to AZ′, and hamburger consumption rises to H 2 pounds. Once again, the hypothetical budget line HH′ that keeps the consumer on U 1 , the original indifference curve, is drawn in. The substitution effect is the movement from point W to point J on U 1 , implying an increase in consumption from H H J 1 to . Now see what happens to hamburger consumption when we move out from budget line HH′ to AZ′, a movement reflecting the income effect of the lower price of hamburger. Because hamburger is an inferior good for this 4.3 86 Chapter Four • Individual and Market Demand • consumer, the income effect reduces hamburger consumption, from H H J to 2 . Overall, how- ever, the total effect of the price reduction is increased consumption, because the substitution effect (greater consumption) is larger than the income effect (lower consumption). In this situation the consumer’s demand curve for hamburger slopes downward. For an inferior good there is another possibility, illustrated in Figure 4.5b. Good X is also an inferior good for some consumers, and a reduction in its price pivots the budget line from AZ to AZ′. Here, however, the total effect of the price decrease is a reduction in the consumption of X, from X 1 to X 2 . When the Income and Substitution Effects are shown 0 U 1 J W W′ U 2 (a) Total S I Hamburger Z Z ′ H ′ H 1 H 2 H J A H 0 U 1 J W W′ U 2 Other goods ( b) Total S I Other goods A H Good X Z Z ′ H ′ X 1 X 2 X J Income and Substitution Effects for an Inferior Good (a) Hamburger is an inferior good with a normally shaped, downward- sloping demand curve, because the substitution effect is larger than the income effect. (b) Good X is an inferior good with an upward-sloping demand curve, because the income effect is larger than the substitution effect. Good X is called a Giffen good. Figure 4.5 • Income and Substitution Effects: Inferior Goods 87 separately, we see how this outcome occurs.

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  Chicago Price Theory

  • Sonia Jaffe, Robert Minton, Casey B. Mulligan, Kevin M. Murphy(Authors)
  • 2019(Publication Date)
  • Princeton University Press

    (Publisher)

  However, consumption is multiplied by an effect that depends on which good’s price changes, whereas the individual Slutsky equation would have ∂ X i / ∂ M , which is properly called an income effect because it is independent of the source of the income (i.e., good j does not appear). Unless everyone has the same income effect, in which case ∂ X i / ∂ M can X 2 X 1 Figure 3-5: After the shift in relative prices, the heavy X 1 consumers buy less of X 1 . M A R S H A L L I A N A N D H I C K S I A N S Y S T E M S 47 be factored out of the sum across people, it makes little sense to refer to an aggregate income effect because it depends on who gets the income. From now on, we draw Marshallian demand curves as downward slop-ing. That is, we rule out the Giffen good case, which means either that the income effect is in the same direction as the substitution effect or that the income effect is sufficiently small. 48 Consumer theory gives us a lot of guidance about how to measure things like real income and GDP; it suggests weighting changes in quantities by prices (more expensive goods are more valuable, so changes in their quantities matter more) and weighting changes in prices by quantities (consumers are more affected by changes in the prices of goods that they buy more). We will look now at several of these weighting schemes, motivated by the cost function we studied in chapter 2. LASPEYRES AND PAASCHE DECOMPOSITIONS OF EXPENDITURE GROWTH Expenditure is the cost of the chosen bundle of goods—the sum of prices times quantities. We can decompose expenditure growth E t + 1 / E t into a price index P t + 1 / P t and a quantity index Q t +1 / Q t : E t + 1 E t = ∑ i X i , t + 1 P i , t + 1 ∑ i X i , t P i , t = ∑ i X i , t P i , t + 1 ∑ i X i , t P i , t × ∑ i X i , t + 1 P i , t + 1 ∑ i X i , t P i , t + 1 = P t + 1 P t × Q t + 1 Q t . It’s especially useful because often we only measure two of the three.

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  Microeconomic Theory

  Basic Principles and Extensions

  • Walter Nicholson, Christopher Snyder(Authors)
  • 2016(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  Copyright 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-300 Chapter 5: Income and Substitution Effects 181 Changing demands for food in China China has one of the fastest growing economies in the world: Its GDP per capita is currently growing at a rate of approx-imately 8 percent per year. Chinese consumers also spend a large fraction of their incomes on food—approximately 38 percent of total expenditures in recent survey data. One implication of the rapid growth in Chinese incomes, however, is that patterns of food consumption are changing rapidly. Purchases of staples, such as rice or wheat, are declining in relative importance, whereas purchases of poultry, fish, and processed foods are growing rapidly. An article by Gould and Villarreal (2006) studies these patterns in detail using the AIDS model. They identify a variety of substitution effects across specific food categories in response to changing relative prices. Such changing patterns imply that a fixed market bas-ket price index (such as the U.S. Consumer Price Index) would be particularly inappropriate for measuring changes in the cost of living in China and that some alternative approaches should be examined. References Aizcorbe, Ana M., and Patrick C. Jackman. “The Commodity Substitution Effect in CPI Data, 1982–91.” Monthly Labor Review (December 1993): 25–33. Feenstra, Robert C., and Marshall B. Reinsdorf. “An Exact Price Index for the Almost Ideal Demand System.” Eco-nomics Letters (February 2000): 159–62. Gould, Brain W., and Hector J. Villarreal. “An Assessment of the Current Structure of Food Demand in Urban China.” Agricultural Economics (January 2006): 1–16. Hausman, Jerry. “Cellular Telephone, New Products, and the CPI.” Journal of Business and Economic Statistics (April 1999): 188–94. Hausman, Jerry. “Sources of Bias and Solutions to Bias in the Consumer Price Index.” Journal of Economic Perspectives (Winter 2003): 23–44.

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  Price Theory and Applications

  • Steven Landsburg(Author)
  • 2013(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  When the substitution effect is larger than the income effect, B is to the left of A (so that X is ordinary) but when the income effect is larger than the substitution effect, B is to the right of A (so that X is Giffen). The two panels of Exhibit 4.12 show that each of these possibilities can occur. Therefore, An inferior good is ordinary if the substitution effect exceeds the income effect, but Giffen if the income effect exceeds the substitution effect. EXHIBIT 4.12 Income and Substitution Effects for an Inferior Good Y 0 X A B C Low price Y 0 X A B C Compensated Low price High price High price Compensated In both panels, X is an inferior good; that is, B is to the right of C. In the first panel, X is ordinary (i.e., not Giffen); that is, B is to the left of A. In the second panel, X is Giffen; that is, B is to the right of A. © Cengage Learning 94 CHAPTER 4 Copyright 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. The economic interpretation is straightforward: When the price of X goes up, the substitution effect (from A to C ) causes the quantity demanded to fall. At the same time, the income effect (from C to B ) causes the quantity demanded to rise (because X is an inferior good). These effects work in opposite directions, so the quantity demanded of X can fall or rise, depending on which effect is bigger. The Size of the Income Effect Suppose the price of bubble gum rises.

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  Handbook of International Economics

  International Monetary Economics and Finance

  • R.W. Jones, P.B. Kenen(Authors)
  • 1988(Publication Date)
  • North Holland

    (Publisher)

  Ch. 20: Income and Price Effects in Foreign Trade 1051 foreign goods. Second, it is possible that international differences in the method- ology of constructing price statistics (e.g. weighting patterns, survey methods, index number formulae) can lead to observed international price differences for a given good or bundle of goods that understate the true degree of substitutability. In other words, some traded industrial goods may be closer substitutes than the (imperfect) price statistics would suggest. Third and finally, there may be insights about price and income elasticities for imports and exports that emerge from a perfect substitutes framework that do not when goods are assumed to be imperfect substitutes. Equations (2.9)-(2.16) below constitute a simple perfect substitutes model of trade for our representative country i: D ; = l ( P , , x ) , 1,<0, 1,>0 (2.9) s; = n( P;, c.), n, > 0, n2 < 0 (2.10) Ii=Di-S,, (2.11) X; = S, - D,, (2.12) PI, = P, = PX, = e . P W ) (2.13) m Ow= c D;, i = l m s, = c s;, i = l D, = S,. (2.14) (2.15) (2.16) In this perfect substitutes model, D, is the total quantity of traded goods demanded in country i; S, is the supply of traded goods produced in country i; I, and X, are the quantities of country i’s imports and exports; PI,, PX,, P,, and P, are the import, export, domestic, and world prices of traded goods; 0, and S, are the world demand and supply of traded goods; and and F, are money income and factor costs in country i. For the purposes of this paper, there are three main features of the perfect substitutes model. First, contrary to the imperfect substitutes model, there are no separate import demand or export supply functions. Instead, the demand for imports and the supply of exports represent the “excess” demand and “excess” supply respectively for domestic goods; see eqs.

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  Intermediate Microeconomics

  An Intuitive Approach with Calculus

  • Thomas Nechyba(Author)
  • 2018(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  In our following example, we assume that he finances his entire consumption by selling oil. George’s income is thus modelled as arising endogenously from the value of his oil endowment. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 154 CHAPTER 8 WEALTH AND SUBSTITUTION EFFECTS IN LABOUR AND CAPITAL MARKETS 8A.1.1 The Substitution Effect Revisited Panel (a) of Graph 8.1 illustrates the impact of an increase in the price of oil on George’s budget. Point E is George’s endowment point – the amount of oil he owns and can choose to consume if he would like to consume only oil and no other consumption. In this case an increase in price causes George’s budget constraint to rotate outwards around his endowment point until its slope reflects the new opportunity cost. Point A denotes George’s optimal consumption bundle prior to the increase in price. We can now divide George’s behavioural response to the price change into two distinct parts. First, we ask how his behaviour would have changed if his real income as measured by the indifference curve he can reach were held constant and he only faced a change in the opportunity cost reflected in the steeper slope. Panel (b) in Graph 8.1 introduces the compensated budget constraint that has the new budget’s slope and its tangent to the original indifference curve reflecting no change in real welfare.

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