Income and Substitution Effects

Economists often separate the impact of a price change into two components: the substitution effect; and the income effect.

The substitution effect involves the substitution of good x₁ for good x₂ or vice-versa due to a change in relative prices of the two goods.It is the component of the total effect of a price change that results from the associated change in the relative attractiveness of other goods. Even if the individual remained on the same indifference curve when the price changes, his optimal choice will change because the MRS must equal the new price ratio.

The income effect results from an increase or decrease in the consumer’s real income or purchasing power as a result of the price change. The price change alters the individual’s “real” income and therefore he must move to a new indifference curve. So this component of the total effect of a price change results from the associated change in real purchasing power.

The sum of these two effects is called the price effect.

The decomposition of the price effect into the income and substitution effect can be done in several ways. There are two main methods:

– The Hicksian method (Sir John R.Hicks (1904-1989) was awarded the Nobel Laureate in Economics (with Kenneth J. Arrow) in 1972 for work on general equilibrium theory and welfare economics);

– 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” he introduced “Slutsky Decomposition”).

According to The Hicksian method:

In the case of decreasing price of X-good the decomposition of price effect can be illustrated with the help of the following graph:

In the case of increasing of the H-good price the Substitution and income effects can be shown like following graph:

If a good is normal (as in both cases), substitution and income effects reinforce one another:

– when price falls, both effects lead to a rise in quantity demanded;

– when price rises, both effects lead to a drop in quantity demanded.

If a good is inferior, substitution and income effects move in opposite directions. The combined effect is indeterminate:

– when price rises, the substitution effect leads to a drop in quantity demanded, but the income effect is opposite;

– when price falls, the substitution effect leads to a rise in quantity demanded, but the income effect is opposite.

If the income effect of a price change is strong enough, there could be a positive relationship between price and quantity demanded:

– an increase in price leads to a drop in real income;

– since the good is inferior, a drop in income causes quantity demanded to rise.

This is the issue of Giffen’s Paradox.

Addition to Lecture 6.

Дата добавления: 2014-01-11