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Effects of a Price Decrease

Can be broken down into two components


Income effect

Separating Income and Substitution Effects


ECON 370: Microeconomic Theory Summer 2004 Rice University Stanley Gilbert

When the price of one goods falls, w/ other constant; Effectively like increase in consumers real income Since it unambiguously expands the budget set Income effect on demand is positive, if normal good

Substitution effect
Measures the effect of the change in the price ratio; Holding some measure of income or well being constant Consumers substitute it for other now relatively more expensive commodities That is, Substitution effect is always negative

Two decompositions: Hicks, Slutsky

Hicks and Slutsky Decompositions


Hicks
Substitution Effect: change in demand, holding utility constant Income Effect: Remaining change in demand, due to m change

Hicks Substitution and Income Effects


Due to Sir John Hicks (1904-1989; Nobel 1972)
To get Substitution Effect: Hold utility constant and find bundle that reflects new price ratio Substitution Effect = change in demand due only to this change in price ratio (movement along IC) Income Effect = remaining change in demand to get back to new budget constraint (parallel shift)

Slutsky
Substitution Effect: change in demand, holding real income constant Income Effect: Remaining change in demand, due to m change

Econ 370 - Ordinal Utility

Econ 370 - Ordinal Utility

Hicks Decomposition Graphically


x2
Given a drop in Price:

Hicks Decomposition Graphically 2


x2
Given a drop in Price: Insert an imaginary budget line tangent to original IC and parallel to new budget line

x2

x2

x1

x1

x1
Substitution Effect Income Effect

x1

Econ 370 - Ordinal Utility

Econ 370 - Ordinal Utility

Slutsky Substitution and Income Effects


Due to Eugene Slutsky (1880-1948)
To get Substitution Effect: Hold purchasing power constant
(that is, adjust income so that the consumer can exactly afford the original bundle)

Slutsky Decomposition Graphically


x2
Given a drop in Price:

x2

and find bundle that reflects new price ratio Substitution Effect = change in demand due only to this change in price ratio (movement along IC) Income Effect = remaining change in demand to get back to new budget constraint (parallel shift)

x1

x1

Econ 370 - Ordinal Utility

Econ 370 - Ordinal Utility

Slutsky Decomposition Graphically 2


x2
Given a drop in Price: Insert an imaginary budget line through the original bundle

Signs of Substitution and Income Effects


Sign of Substitution Effect is unambiguously negative as long as Indifference Curves are convex Income effect may be positive or negative
That is, the good may be either normal or inferior

x2

For Normal goods, the income effect reinforces the substitution effect For Inferior goods, the two effects offset For Giffen Goods
Remember, the Income effect is Negative And the income effect is greater than the substitution effect

x1
Substitution Effect Income Effect
Econ 370 - Ordinal Utility

x1

Econ 370 - Ordinal Utility

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Slutskys Effects for Normal Goods


x2
From Before Since Substitution Effect and Income Effect reinforce each other This is a Normal Good

Slutskys Effects for Inferior Goods


x2
In this case: Since Substitution Effect and Income Effect offset each other This is an Inferior Good

x2

x2

x1
Substitution Effect Income Effect
Econ 370 - Ordinal Utility

x1

x1
Substitution Effect Income Effect
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x1

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Slutskys Effects for Giffen Goods


x2
In this case: Since Income Effect completely cancels the Substitution Effect This is a Giffen Good

Mathematics of Slutsky Decomposition


We seek a way to calculate mathematically the Income and Substitution Effects Assume:
Income: m Initial prices: p10, p2 Final prices: p11, p2 Note that the price of good two, here, does not change

x2

Given the demand functions, demands can be readily calculated as: x1


Substitution Effect Income Effect

x1

Initial demands: xi0 = xi( p10, p2, m) Final demands: xi1 = xi( p11, p2, m)
13 Econ 370 - Ordinal Utility 14

Econ 370 - Ordinal Utility

Slutsky Mathematics (cont)


We need to calculate an intermediate demand that holds buying power constant Let ms the income that provides exactly the same buying power as before at the new price
Thus: ms = p11x10 + p2x20

Hicks Mathematics
The only difference is between Hicks and Slutsky is in the calculation of the intermediate demand Let mh the income that provides exactly the same utility as before at the new price
If u0 is initial utility level, then Thus: mh solves u0 = u( x1(p11, p2, mh), x2(p11, p2, mh))

The demand associated with this income is:


xis = xi( p11, p2, ms) = xis( p11, p2, x10, x20)

The demand associated with this income is:


xih = xi( p11, p2, mh) = xih( p11, p2, u0)

Finally we have:
Substitution Effect: Income Effect:
Econ 370 - Ordinal Utility

Finally we have:
SE = xis xi0 IE = xi1 xis
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Substitution Effect: Income Effect:


Econ 370 - Ordinal Utility

SE = xih xi0 IE = xi1 xih


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Calculating the Slutsky Decomposition


Assume that u = xy1 So the demand functions are: x = m px y = (1 ) m py

Calculating the Slutsky Decomposition 2


p1 s x + (1 ) m Since m = 0 px

Initial Price is px0


x0 = m p0 x
+ py y =
x1 = m p1 x

Final Price is px1


y 0 = y1 = y = m py

We get: ms m p1 x + (1 ) = 2 m + (1 ) m x s = 1 = 1 0 0 px px px px p1 x or x s = x 0 + (1 )x1

Finally, we get:

m =

0 p1 xx

p1 x

p1 m m x ( ) + 1 p = y 0 + (1 ) m 0 p px y px
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SE = x s x 0 = x 0 + (1 )x1 x 0 = (1 ) x1 x 0 IE = x1 x s = x1 x 0 + (1 )x1 = x1 x 0
Econ 370 - Ordinal Utility

] (

)
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Econ 370 - Ordinal Utility

Calculating the Hicks Decomposition


We need to calculate mh, so Substituting our demand functions back into utility we get:
m m u = x y1 = (1 ) py px Then mh solves: p1 x

1

Calculating the Hicks Decomposition 2


Since We get:
xh =
p1 x mh = p0 m x

= px

1 p y

mh = p0 x

1 p y

m
1

mh m p1 m x = = 1 1 0 0 1 px px p x px px

( ) ( )1

1 p y

Finally, we get:
p1 x SE = x x = x 0 x0 px
s 0
19 Econ 370 - Ordinal Utility

or

p1 x mh = p0 m x

p1 x IE = x x = x x 0 px
1 s 1

Econ 370 - Ordinal Utility

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Demand Curves
We have already met the Marshallian demand curve
It was demand as price varies, holding all else constant

Demand Curves (cont)


We mentioned before that with Giffen Goods, the Marshallian demand curve slopes upward However,
Since the substitution effect is always negative, Then Both the Slutsky and Hicks Demands always slope downwardeven with Giffen Goods

There are two other demand curves that are sometimes used Slutsky Demand
Change in demand holding purchasing power constant The function xis = xi( p11, p2, ms) we just defined

Hicks Demand
Change in demand holding utility constant The function xih = xi( p11, p2, mh) we just defined
Econ 370 - Ordinal Utility 21 Econ 370 - Ordinal Utility 22

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