Income and Substitution Effects

• We know that both

Income and Substitution Effects price and income
influence demand.

Lectures in Microeconomics-Charles W. Upton Income and Substitution Effects

Income and Substitution Effects Income and Substitution Effects

• We know that both • We know that both • You are purchasing
price and income price and income 10 apples at $1
influence demand. influence demand. each.
• A price change • A price change • If the price falls to
means an income means an income 50¢, you effectively
change. change. get $5 more income

Income and Substitution Effects Income and Substitution Effects

The Basic Indifference Curve The Basic Indifference Curve

Yo Utility Yo Utility
Maximization Maximization
Your income
is Yo; you
could
purchase up
I1 to
I1 Yo/po
apples

A A
Yo/po
Income and Substitution Effects Yo/po
Income and Substitution Effects

1
 The Basic Indifference Curve Apple Prices Drop
Yo are on
You Utility Yo
indifference Maximization
curve I1

I1 I1

A A
Yo/po
Income and Substitution Effects Yo/po Yo/p1
Income and Substitution Effects

Apple Prices Drop Apple Prices Drop

Yo I2 The budget line Yo I2 The budget line
rotates out and rotates out and
you move to you move to
indifference Two things have indifference
curve I2 occurred: a price curve I2
cut and an
increase in
I1 I1
income

A A
Yo/po Yo/p1
Income and Substitution Effects Yo/po Yo/p1
Income and Substitution Effects

Apple Prices Drop The Substitution Effect

To isolate the effect of the
lower price, imagine a
Yo I2 The budget line Yo I2 budget line reflecting the
rotates out and lower price but tangent to
you move to the old indifference curve
Two things have
Lets separate indifference
occurred: a those
price two effects curve I2
cut and anstarting with the
increasesubstitution
in effect
I1 I1
income

A A
Yo/po Yo/p1
Income and Substitution Effects Yo/po Yo/p1
Income and Substitution Effects

2
 We would move
The Substitution to Effect
To isolate the red
the effect
dotof the
lower price, imagine a
Yo I2 budget line reflecting the
lower price but tangent to
the old indifference curve
We would move
This The
is theSubstitution to Effect
To isolate the red
the effect
dotof the
substitution effect lower price, imagine a
Yo I2 budget line reflecting the
lower price but tangent to
the old indifference curve

I1 I1

A A
Yo/po Yo/p1
Income and Substitution Effects Yo/po Yo/p1
Income and Substitution Effects

We would move
This The
is theSubstitution to Effect
To isolate the red
the effect
dotof the The Income Effect
substitution effect lower price, imagine a
The
Yo I2 budget line reflecting the Yo I2
lower price but tangent to substitution
The substitution
the old indifference curve effect is only
effect is always part of the
negative - story
Diminishing MRS
guarantees it I1 I1

A A
Yo/po Yo/p1
Income and Substitution Effects Yo/po Yo/p1
Income and Substitution Effects

The other part of the The other part of the

The Incomeimpact of the price
Effect The Incomeimpact of the price
Effect
change is the change is the
Yo I2 The Yo I2 The
movement from the movement from the
substitution substitution
red dot to the green red dot to the green
effect is only effect is only
dot dot
part of the part of the
story This is the story
income effect
I1 I1

A A
Yo/po Yo/p1
Income and Substitution Effects Yo/po Yo/p1
Income and Substitution Effects

3
 The Combined Effect WhileThe
the Combined Effect
substitution
Yo I2 We effectively Y I2 We effectively
effect
o is
break the price break the price
always
change down change down
negative, the
into its two into its two
income
components: components:
effect may
the substitution the substitution
or not be
effect
I1 and the effect
I1 and the
positive
income effect. income effect.
A A
Yo/po Yo/p1
Income and Substitution Effects Yo/po Yo/p1
Income and Substitution Effects

Change in Quantity Demanded for Normal and Inferior Change in Quantity Demanded for Normal and Inferior
Goods Goods

Normal Inferior Normal Inferior

Good Good Good Good

Price Price Price Price Price Price Price Price

↑ ↓ ↑ ↓ ↑ ↓ ↑ ↓
Change in quantity demanded (-) (+) (-) (+) Change in quantity demanded (-) (+) (-) (+)
due to substitution effect (holding due to substitution effect (holding
utility constant) utility constant)
Change due to income effect (-) (+) (+) (-) Change due to income effect (-) (+) (+) (-)
(holding prices constant) (holding prices constant)
Combined Effect (-) (+) ? ? Combined Effect (-) (+) ? ?

Income and Substitution Effects Income and Substitution Effects

Change in Quantity Demanded for Normal and Inferior Change in Quantity Demanded for Normal and Inferior
Goods Goods

Normal Inferior Normal Inferior

Good Good Good Good

Price Price Price Price Price Price Price Price

↑ ↓ ↑ ↓ ↑ ↓ ↑ ↓
Change in quantity demanded (-) (+) (-) (+) Change in quantity demanded (-) (+) (-) (+)
due to substitution effect (holding due to substitution effect (holding
utility constant) utility constant)
Change due to income effect (-) (+) (+) (-) Change due to income effect (-) (+) (+) (-)
(holding prices constant) (holding prices constant)
Combined Effect (-) (+) ? ? Combined Effect (-) (+) ? ?

Income and Substitution Effects Income and Substitution Effects

4
 End

©2006 Charles
W. Upton

Income and Substitution Effects