Income and Substitution Effects
Income and Substitution Effects
• We know that both price and income influence demand.
Income and Substitution Effects
Income and Substitution Effects
• We know that both price and income influence demand.
• A price change means an income change.
Income and Substitution Effects
Income and Substitution Effects
• We know that both price and income influence demand.
• A price change means an income change.
• You are purchasing 10 apples at $1 each.
• If the price falls to 50¢, you effectively get $5 more income
Income and Substitution Effects
The Basic Indifference CurveYo
A
I1
Utility Maximization
Yo/po
Your income is Yo; you
could purchase up
to Yo/po apples
Income and Substitution Effects
The Basic Indifference CurveYo
A
I1
Utility Maximization
Yo/po
You are on indifference
curve I1
Income and Substitution Effects
Apple Prices DropYo
A
I1
Yo/poYo/p1
The budget line rotates out and
you move to indifference
curve I2
I2
Income and Substitution Effects
Apple Prices DropYo
A
I1
Yo/poYo/p1
The budget line rotates out and
you move to indifference
curve I2
I2
Two things have occurred: a price
cut and an increase in
income
Income and Substitution Effects
Apple Prices DropYo
A
I1
Yo/poYo/p1
The budget line rotates out and
you move to indifference
curve I2
I2
Two things have occurred: a price
cut and an increase in
income
Lets separate those two effects starting with the
substitution effect
Income and Substitution Effects
The Substitution EffectYo
A
I1
Yo/poYo/p1
To isolate the effect of the lower price, imagine a
budget line reflecting the lower price but tangent to the old indifference curve
I2
Income and Substitution Effects
The Substitution EffectYo
A
I1
Yo/poYo/p1
To isolate the effect of the lower price, imagine a
budget line reflecting the lower price but tangent to the old indifference curve
I2
We would move to the red dot
Income and Substitution Effects
The Substitution EffectYo
A
I1
Yo/poYo/p1
To isolate the effect of the lower price, imagine a
budget line reflecting the lower price but tangent to the old indifference curve
I2
We would move to the red dotThis is the
substitution effect
Income and Substitution Effects
The Substitution EffectYo
A
I1
Yo/poYo/p1
To isolate the effect of the lower price, imagine a
budget line reflecting the lower price but tangent to the old indifference curve
I2
We would move to the red dotThis is the
substitution effect
The substitution effect is always
negative - Diminishing MRS
guarantees it
Income and Substitution Effects
The Income EffectYo
A
I1
Yo/poYo/p1
I2The
substitution effect is only
part of the story
Income and Substitution Effects
The Income EffectYo
A
I1
Yo/poYo/p1
I2The
substitution effect is only
part of the story
The other part of the impact of the price
change is the movement from the red dot to the green
dot
Income and Substitution Effects
The Income EffectYo
A
I1
Yo/poYo/p1
I2The
substitution effect is only
part of the story
The other part of the impact of the price
change is the movement from the red dot to the green
dotThis is the
income effect
Income and Substitution Effects
The Combined EffectYo
A
I1
Yo/poYo/p1
I2We effectively break the price change down
into its two components:
the substitution effect and the income effect.
Income and Substitution Effects
The Combined EffectYo
A
I1
Yo/poYo/p1
I2We effectively break the price change down
into its two components:
the substitution effect and the income effect.
While the substitution
effect is always
negative, the income
effect may or not be positive
Income and Substitution Effects
Change in Quantity Demanded for Normal and Inferior Goods
Normal Good
Inferior Good
Price ↑
Price ↓
Price ↑
Price ↓
Change in quantity demanded due to substitution effect (holding utility constant)
(-) (+) (-) (+)
Change due to income effect (holding prices constant)
(-) (+) (+) (-)
Combined Effect (-) (+) ? ?
Income and Substitution Effects
Change in Quantity Demanded for Normal and Inferior Goods
Normal Good
Inferior Good
Price ↑
Price ↓
Price ↑
Price ↓
Change in quantity demanded due to substitution effect (holding utility constant)
(-) (+) (-) (+)
Change due to income effect (holding prices constant)
(-) (+) (+) (-)
Combined Effect (-) (+) ? ?
Income and Substitution Effects
Change in Quantity Demanded for Normal and Inferior Goods
Normal Good
Inferior Good
Price ↑
Price ↓
Price ↑
Price ↓
Change in quantity demanded due to substitution effect (holding utility constant)
(-) (+) (-) (+)
Change due to income effect (holding prices constant)
(-) (+) (+) (-)
Combined Effect (-) (+) ? ?
Income and Substitution Effects
Change in Quantity Demanded for Normal and Inferior Goods
Normal Good
Inferior Good
Price ↑
Price ↓
Price ↑
Price ↓
Change in quantity demanded due to substitution effect (holding utility constant)
(-) (+) (-) (+)
Change due to income effect (holding prices constant)
(-) (+) (+) (-)
Combined Effect (-) (+) ? ?