Price Change: Income and
Substitution Effects
THE IMPACT OF A PRICE
CHANGE

Economists often separate the
impact of a price change into two
components:
– the
h substitution
b i i effect;
ff
and
d
– the income effect.
THE IMPACT OF A PRICE
CHANGE



The substitution effect involves the
substitution of good x1 for good x2 or viceversa due to a change in relative prices of
the two goods.
The income effect
ff
results from
f
an increase
or decrease in the consumer’s real income
or purchasing power as a result of the
price change.
The sum of these two effects is called the
price effect.
THE IMPACT OF A PRICE
CHANGE
The decomposition of the price effect
into the income and substitution
effect can be done in several ways
 There
Th
are two main
i methods:
h d
(i) The Hicksian method; and
(ii) The Slutsky method

THE HICKSIAN METHOD
Sir John R.Hicks (1904-1989)
(1904 1989)
 Awarded the Nobel Laureate in
E
Economics
i (with
( ith Kenneth
K
th J.
J Arrrow)
A
)
in 1972 for work on general
equilibrium theory and welfare
economics.

THE HICKSIAN METHOD
Optimal bundle is Ea, on
indifference curve I1.
X2
Ea
I1
xa
X1
THE HICKSIAN METHOD
A ffall
ll in
i the
th price
i off X1
X2
The budget
g line pivots
p
out from P
*
P
Ea
I1
xa
X1
THE HICKSIAN METHOD
The new optimum is
Eb on I2.
X2
The Total Price
Effect is xa to xb
Ea
Eb
I2
I1
xa
xb
X1
THE HICKSIAN METHOD


To isolate the substitution effect we ask….
what would the consumer
consumer’s
s optimal
“what
bundle be if s/he faced the new lower price
for X1 but experienced no change in real
income?”
This amounts to returning the consumer
to the original indifference curve (I1)
THE HICKSIAN METHOD
The new optimum is
Eb on I2.
X2
The Total Price
Effect is xa to xb
Ea
Eb
I2
I1
xa
xb
X1
THE HICKSIAN METHOD
Draw a line parallel to
the new budget line and
tangent to the old
indifference curve
X2
Ea
Eb
I2
I1
xa
xb
X1
THE HICKSIAN METHOD
The new optimum on I1 is
at Ec. The movement from
Ea to Ec (the increase in
quantity demanded from
Xa to Xc) is solely in
response to a change in
Eb
relative prices
I2
X2
Ea
Ec I1
xa xc
xb
X1
THE HICKSIAN METHOD
This is
Thi
i the
th
substitution effect.
X2
Eb
Ea
I2
Ec
I1
Xa
Substitution
S
b tit ti
Effect
Xc
X1
THE HICKSIAN METHOD
To isolate the income effect …
 Look at the remainder of the total
price effect
 This is due to a change in real
income.

THE HICKSIAN METHOD
The remainder of the total
effect is due to a change
in real income. The
increase in real income is
evidenced by
y the
movement from I1 to I2
Eb
I2
X2
Ea
Ec
I1
Xc
X1
Income Effect
ff
Xb
THE HICKSIAN METHOD
X2
Eb
Ea
I2
Ec
I1
xa xc
xb
Sub
S
b Income
I
Effect Effect
X1
HICKSIAN ANALYSIS and DEMAND CURVES
P
A fall in price
from p1 to p1*
M1  p1 x1  p2 x2
AC
P
P1
P1*
B
M1  p1 x1  p2 x2
X1
Marshallian Demand
Curve (A & B)
A
B
C
Hicksian Demand
Curve (A & C)
X1
HICKSIAN ANALYSIS and DEMAND
CURVES
Hicksian (compensated) demand
curves cannot be upward
upward-sloping
sloping
(i.e. substitution effect cannot be
positive)
THE SLUTSKY METHOD
Eugene Slutsky (1880-1948)
 Russian economist expelled from the
University of Kiev for participating in
student revolts.
 In his 1915 paper, “On the theory of
the Budget of the Consumer”
Consumer he
introduced “Slutsky Decomposition”.

THE SLUTSKY METHOD
Optimal bundle is Ea, on
indifference curve I1.
X2
Ea
I1
xa
X1
THE SLUTSKY METHOD
A ffall
ll in
i the
th price
i off X1
X2
The budget
g line pivots
p
out from P
*
P
Ea
I1
xa
X1
THE SLUTSKY METHOD
The new optimum is
Eb on I2.
X2
The Total Price
Effect is xa to xb
Ea
xa
Eb
I1
xb
I2
X1
THE SLUTSKY METHOD


Slutsky claimed that if, at the new prices,
– less income is needed to buy the original
bundle then “real income” has increased
– more income is needed to buy the
original bundle then “real income” has
decreased
Slutsky isolated the change in demand due
only to the change in relative prices by
asking “What is the change in demand
when the consumer’s income is adjusted
so that,
th t att the
th new prices,
i
s/he
/h can just
j t
afford to buy the original bundle?”
THE SLUTSKY METHOD
To isolate the substitution effect we
adjust the consumer’s
consumer s money
income so that s/he change can just
afford the original consumption
bundle.
 In other words we are holding
purchasing power constant.

THE SLUTSKY METHOD
The new optimum is
Eb on I2.
X2
The Total Price
Effect is xa to xb
Ea
xa
Eb
I1
xb
I2
X1
THE SLUTSKY METHOD
Draw a line parallel
to the new budget
line which passes
through the point
Ea
Ea.
X2
Eb
Ea
I2
I1
xa
xb
X1
THE SLUTSKY METHOD
The new optimum
on I3 is
i att Ec.
E The
Th
movement from Ea
t E
to
Ec iis the
th
substitution effect
X2
Eb
Ea
Ec
xa
xc xb
I2
I3
X1
THE SLUTSKY METHOD
The new optimum
on I3 is
i att Ec.
E The
Th
movement from Ea
t E
to
Ec iis the
th
substitution effect
X2
Eb
Ea
Ec
xa
I2
I3
xc
Substitution Effect
X1
THE SLUTSKY METHOD
The remainder of
th total
the
t t l price
i effect
ff t
is the Income Effect.
X2
The movement from
Ec to Eb.
Eb
Ea
Ec
xc
I2
I3
xb
Income Effect
X1
THE SLUTSKY METHOD for NORMAL
GOODS
Most goods are normal (i.e. demand
increases with income).
income)
 The substitution and income effects
reinforce
i f
each
h other
h when
h a normall
good’s own price changes.
g
g

THE SLUTSKY METHOD for
NORMAL GOODS
The income and
substitution
b tit ti effects
ff t
reinforce each
other.
th
X2
Eb
Ea
Ec
xa
xc
I2
I3
xb
X1
THE SLUTSKY METHOD for NORMAL
GOODS
Since both the substitution and
income effects increase demand
when own-price falls, a normal
good’s ordinary demand curve
slopes downwards.
 The “Law” of Downward-Sloping
Demand therefore always applies to
normal goods.

THE SLUTSKY EQUATION
Q
Let
M 1  p1 x 1  p 2 x 2
be the original budget constraint
and let
M
2
 p 1 x 1  p 2 x 2
represent the budget constraint after the
Slutsky compensating variation in income
has been carried out.
THE S
SLUTSKY
U S
EQUATION
QU
ON
X2
M2 < M1
Demand for x1 is
x1  x  p1, p2 , M 
d
M1  p1 x1  p2 x2
Ea
xa
M2  p1x1  p2 x2
X1
THE SLUTSKY EQUATION
M2 - M1
M  M 2  M 1 

M  M 2  M 1 

p1 x1
 p2 x2 - p1 x1  p2 x2
M  M 2  M 1 

p1 x1
- p1 x1
M  M 2  M 1 

x1 p1
M  x1p1 as

p1 x1



p1

 p2 x2 -  p1 x1  p2 x2 
- p1


- p1  p1
gives
i
the
th change
h
in
i money
income needed to
consume the original
bundle of goods (at EA)
M=x1p
p1
THE S
SLUTSKY
U S
EQUATION
QU
ON
The demand curve holding
gM
constant is given by
 x1  x
d


p1 ,

p2 , M 1  x
d
 p1 , p2 , M 1 
(1)
which is the change in demand for x1 due to
the change in its own price, holding M and
the price of x2 constant
THE SLUTSKY EQUATION
Q
The income effect is given by



 x m  x d p1 , p2 , M 1  x d p1 , p2 , M 2

(2)
The change in demand due to the Slutsky
substitution effect is given by


 x s  x d p1 , p2 , M 2  x d  p1 , p2 , M 1 
(3)
THE SLUTSKY EQUATION
Given
 p , M  x  p , p , M 
 x  p , p , M  x  p , p , M 
 x  p , p , M  x  p , p , M 
 x1  x
d
x m
d
x s
d

p1 ,

1

1
d
2
1
d
2
1
1
2
1
(1)

1
2
2
(2)
d
2
2
1
2
1
(3)
Claim
x1  x s  x m
(4)
Show this by substituting equations (1), (2)
and (3) into equation (4)
THE SLUTSKY EQUATION
Q
x1  x s  x m
Divide across by p1
x1 x s x m


p1 p1 p1
Recall
so
M  x1p1
p1  () M x1
THE SLUTSKY EQUATION
Q
Substituting
p1  ()M x1
x1 xs xm


p1 p1 p1
Gives
x1 x s x m


x1
p1 p1 M
THE
SLUTSKY
EQUATION
THE SLUTSKY METHOD: INFERIOR
GOODS
Some goods are (sometimes) inferior
(i e demand is reduced by higher
(i.e.
income).
 The
Th substitution
b i i and
d income
i
effects
ff
“oppose” each other when an
inferior good’s own price changes.

THE SLUTSKY METHOD: INFERIOR
GOODS
X2
Eb
I2
The substitution
effect
ff t iis as per
usual. But, the
i
income
effect
ff t is
i
in the opposite
di
direction.
ti
Ea
Ec
xa
I3
xb xc
X1
xa to xc
xc to xb
GIFFEN GOODS
In rare cases of extreme inferiority,
the income effect may be larger in
size than the substitution effect,
causing quantity demanded to rise
as own price falls.
 Such goods are Giffen goods.
 Giffen goods are very inferior goods.
goods

THE SLUTSKY METHOD for
INFERIOR GOODS
In rare cases of
extreme
t
iincomeinferiority, the income
effect may be larger
in size than the
substitution effect,
effect
causing quantity
demanded
de
a ded to fall
a as
own-price falls.
X2
Eb
I2
Ea
Ec
xa to xc
xb xa
I3
xc
X1
xc to xb
SLUTSKY’S EFFECT FOR
GIFFEN GOODS

Slutsky’s decomposition of the effect
of a price change into a pure
substitution effect and an income
effect thus explains why the “Law” of
Downward-Sloping Demand is
violated for very inferior goods.
DECOMPOSITION of TOTAL PRICE EFFECT:
PERFECT COMPLEMENTS
X2
A fall in the price of X1
I1
I2
B
Original
Budget
Constraint
No substitution
effect
New
Budget
Constraint
A=C
X1
DECOMPOSITION of TOTAL PRICE EFFECT
PERFECT SUBSTITUTES
?