Income and Substitution Effects
Lectures in Microeconomics-Charles W. Upton
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 Curve
Yo
Utility
Maximization
I1
Yo/po
Income and Substitution Effects
A
The Basic Indifference Curve
Yo
Utility
Maximization
Your income
is Yo; you
could
purchase up
to
Y
/p
o
o
I1
apples
Yo/po
Income and Substitution Effects
A
The Basic Indifference Curve
Yo are on
You
indifference
curve I1
Utility
Maximization
I1
Yo/po
Income and Substitution Effects
A
Apple Prices Drop
Yo
I1
Yo/po
Income and Substitution Effects
Yo/p1 A
Apple Prices Drop
Yo
I2
The budget line
rotates out and
you move to
indifference
curve I2
I1
Yo/po
Income and Substitution Effects
Yo/p1 A
Apple Prices Drop
Yo
I2
Two things have
occurred: a price
cut and an
increase in
income
The budget line
rotates out and
you move to
indifference
curve I2
I1
Yo/po
Income and Substitution Effects
Yo/p1 A
Apple Prices Drop
Yo
I2
The budget line
rotates out and
you move to
Two things have
Lets separate indifference
occurred: a those
price two effects curve I2
cut and an
starting with the
increasesubstitution
in
effect
I1
income
Yo/po
Income and Substitution Effects
Yo/p1 A
To isolate
the effect of the
The Substitution
Effect
Yo
I2
lower price, imagine a
budget line reflecting the
lower price but tangent to
the old indifference curve
I1
Yo/po
Income and Substitution Effects
Yo/p1 A
The
Yo
We would move
To isolate
the red
effectdot
of the
Substitution
to Effect
the
I2
lower price, imagine a
budget line reflecting the
lower price but tangent to
the old indifference curve
I1
Yo/po
Income and Substitution Effects
Yo/p1 A
We would move
This The
is theSubstitution
To isolate
the red
effectdot
of the
to Effect
the
lower price, imagine a
substitution effect
I2
Yo
budget line reflecting the
lower price but tangent to
the old indifference curve
I1
Yo/po
Income and Substitution Effects
Yo/p1 A
We would move
This The
is theSubstitution
To isolate
the red
effectdot
of the
to Effect
the
lower price, imagine a
substitution effect
I2
Yo
budget line reflecting the
lower price but tangent to
the old indifference curve
The substitution
effect is always
negative Diminishing MRS
guarantees it
Yo/po
Income and Substitution Effects
I1
Yo/p1 A
The Income Effect
Yo
The
substitution
effect is only
part of the
story
I2
I1
Yo/po
Income and Substitution Effects
Yo/p1 A
The
Yo
The other part of the
of the price
Incomeimpact
Effect
change is the
The
I2
movement from the
substitution
red dot to the green
effect is only
dot
part of the
story
I1
Yo/po
Income and Substitution Effects
Yo/p1 A
The
Yo
This is the
income effect
The other part of the
of the price
Incomeimpact
Effect
change is the
The
I2
movement from the
substitution
red dot to the green
effect is only
dot
part of the
story
I1
Yo/po
Income and Substitution Effects
Yo/p1 A
The Combined Effect
Yo
I2
We effectively
break the price
change down
into its two
components:
the substitution
effect
I1 and the
income effect.
Yo/po
Income and Substitution Effects
Yo/p1 A
WhileThe
the Combined Effect
substitution
We effectively
I
Y
2
effect
is
o
break the price
always
change down
negative, the
into its two
income
components:
effect may
the substitution
or not be
effect
and the
I
positive
1
income effect.
Yo/po
Income and Substitution Effects
Yo/p1 A
Change in Quantity Demanded for Normal and Inferior
Goods
Normal
Good
Change in quantity demanded
due to substitution effect (holding
utility constant)
Change due to income effect
(holding prices constant)
Combined Effect
Inferior
Good
Price
↑
Price
↓
Price
↑
Price
↓
(-)
(+)
(-)
(+)
(-)
(+)
(+)
(-)
(-)
(+)
?
?
Income and Substitution Effects
Change in Quantity Demanded for Normal and Inferior
Goods
Normal
Good
Change in quantity demanded
due to substitution effect (holding
utility constant)
Change due to income effect
(holding prices constant)
Combined Effect
Inferior
Good
Price
↑
Price
↓
Price
↑
Price
↓
(-)
(+)
(-)
(+)
(-)
(+)
(+)
(-)
(-)
(+)
?
?
Income and Substitution Effects
Change in Quantity Demanded for Normal and Inferior
Goods
Normal
Good
Change in quantity demanded
due to substitution effect (holding
utility constant)
Change due to income effect
(holding prices constant)
Combined Effect
Inferior
Good
Price
↑
Price
↓
Price
↑
Price
↓
(-)
(+)
(-)
(+)
(-)
(+)
(+)
(-)
(-)
(+)
?
?
Income and Substitution Effects
Change in Quantity Demanded for Normal and Inferior
Goods
Normal
Good
Change in quantity demanded
due to substitution effect (holding
utility constant)
Change due to income effect
(holding prices constant)
Combined Effect
Inferior
Good
Price
↑
Price
↓
Price
↑
Price
↓
(-)
(+)
(-)
(+)
(-)
(+)
(+)
(-)
(-)
(+)
?
?
Income and Substitution Effects
End
©2006 Charles
W. Upton
Income and Substitution Effects