BITS Pilani

Pilani Campus

Income and Substitution Effects

Prof. Geetilaxmi Mohapatra 1
 Outline
• Change in Income
• Income consumption Curve and Engel Curve
• Change in Price
• Price Consumption curve
• Concept of Income effect and Substitution
• Derivation of Compensated and Uncompensated demand
curve
• Compensating Variation and Equivalent variation
• Effect on consumer surplus
• Revealed Preference Theory
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Demand Functions
The optimal levels of x1,x2,…,xn can be expressed as functions of all
prices and income
x1* = d1(p1,p2,…,pn,I)
x2* = d2(p1,p2,…,pn,I)
•
•
•
xn* = dn(p1,p2,…,pn,I)
• If there are only two goods (x and y), we can simplify the notation
x* = x(px,py,I)
y* = y(px,py,I)
• Prices and income are exogenous

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Homogeneity

If all prices and income were doubled, the optimal

quantities demanded will not change
– the budget constraint is unchanged
xi* = xi(p1,p2,…,pn,I) = xi(tp1,tp2,…,tpn,tI)

Individual demand functions are homogeneous of

degree zero in all prices and income

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Changes in Income only
An increase in income will cause the budget constraint to shift
out in a parallel fashion
Since px/py does not change, the individual moves to higher
levels of satisfaction
Income-consumption curve shows how consumption of both
goods changes when income changes, while prices are held
constant.
Engel curve - the relationship between the quantity demanded
of a single good and income, holding prices constant
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 Increase in Income:
Normal and Inferior Goods
If both x and y increase as income rises, x and y are
normal goods
Quantity of y

As income rises, the individual chooses

to consume more x and y

Quantity of x
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Effect of an Increase in Income

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 Increase in Income: Normal
and Inferior Goods
If x decreases as income rises, x is an inferior good
Quantity of y

As income rises, the individual chooses

to consume less x and more y

Quantity of x

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Normal and Inferior Goods
Example: Backward Bending ICC and
Engel Curve – a good can be normal over
some ranges and inferior over others

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Income Consumption Curve:
Normal and Inferior Goods

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 Changes in a Good’s Price:
Price Consumption Curve and Individual Demand curve
• A change in the price of a good alters the slope of the budget constraint
• It changes the consumer’s utility-maximizing choices
PY = $4
Individual Demand Curve
I = $40
For Commodity X
And Px ↓

BITS Pilani, Pilani Campus

 BITS Pilani
Pilani Campus

Income and Substitution Effects

Prof. Geetilaxmi Mohapatra12
 Outline
• Change in Income
• Income Consumption Curve and Engel Curve
• Change in Price
• Price Consumption curve
• Concept of Income Effect and Substitution
• Derivation of Compensated and Uncompensated demand
curve
• Compensating Variation and Equivalent variation
• Effect on consumer surplus
• Revealed Preference Theory
BITS Pilani, Pilani Campus
 Changes in a Good’s Price:
Price Consumption Curve and Individual Demand curve
• A change in the price of a good alters the slope of the budget constraint
• It changes the consumer’s utility-maximizing choices
PY = $4
Individual Demand Curve
I = $40
For Commodity X
And Px ↓

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THE IMPACT OF A PRICE CHANGE

Economists often separate the impact of a price

change into two components:
–substitution effect
–income effect

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THE IMPACT OF A PRICE CHANGE

• The substitution effect involves the substitution of

good X for good Y or vice-versa due to a change in
relative prices of the two goods.
• 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 sum of these two effects is called the price
effect.

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The Substitution Effect and Income Effect of the
change in price
• Substitution effect. • Income effect
• As the Px ↓, all else constant, • As the Px ↓, all else constant,
good X becomes cheaper purchasing power ↑ and vice
relative to good Y and vice versa.
versa.
• The substitution effect is •The income effect may be
always (-)ve. (+)ve or (-)ve.

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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 are two main methods:
• (i) The Hicksian method; and
• (ii) The Slutsky method

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THE HICKSIAN METHOD

• Sir John R.Hicks (1904-1989)

• Awarded the Nobel Laureate in Economics
(with Kenneth J. Arrrow) in 1972 for work on
general equilibrium theory and welfare
economics.

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1) Changes in a Good’s Price:
Price of X ↓

Suppose the consumer is initially

maximizing utility at point A.
If the Px ↓, the consumer will maximize
utility at point B.

Total Effect or Price Effect =AB

i.e the change in Qx

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1) Changes in a Good’s Price:
Price of X ↓

The substitution effect is the movement

from point A to point C

The individual substitutes x for y

because it is now relatively cheaper

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 1) Changes in a Good’s Price :
Price of X ↓

The income effect is the movement

from point C to point B

If x is a normal good,
the individual will buy more because
“real” income increased

Total Effect or Price Effect(AB) = Substitution Effect (AC) + Income Effect (CB)
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Changes in a Good’s Price:
Price of X ↑

An ↑ in the PX →the budget constraint gets steeper

The substitution effect is the movement from

point A to C
The income effect is the movement from
point C to B
Total Effect or Price Effect (AB) =
Substitution Effect (AC) + Income
Effect (CB)

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INCOME AND SUBSTITUTION EFFECTS:
INFERIOR GOOD: For ↓ PF
Consumer is initially at point A
With a ↓ PF, the consumer
moves to point B.
i) a substitution effect, F1E
(movement from A to D),
ii) an income effect, EF2
(movement from D to B).
In this case, food is an inferior
good because the IE is
negative.

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IE and SE for A Special Case:
The Giffen Good
•Consumer is initially at A
• After the ↓PF, moves to B
• The income effect F2F1 >
the substitution effect EF2,
• IE > SE
• The ↓Pfood leads to a lower
quantity of food demanded.
• Q. What is the shape of
the demand curve?

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Inferior good and Giffen Paradox

For inferior goods, no definite prediction can be made

for changes in price
– the SE and IE move in opposite directions
– if the IE outweighs the SE , we have a case of Giffen’s
paradox
• Law of demand may or may not hold true.

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 BITS Pilani
Pilani Campus

Income and Substitution Effects

Prof. Geetilaxmi Mohapatra27
 Outline
• Change in Income
• Income Consumption Curve and Engel Curve
• Change in Price
• Price Consumption curve
• Concept of Income Effect and Substitution
• Derivation of Compensated and Uncompensated demand
curve
• Compensating Variation and Equivalent variation
• Effect on consumer surplus
• Revealed Preference Theory
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 UnCompensated versus Compensated
Demand Curve
The demand curves shown so far have all been
uncompensated, or Marshallian demand curves.
• Consumer utility is allowed to vary with the price of
the good.
Alternatively, we have a compensated, or Hicksian,
demand curve.
–It shows how quantity demanded changes when price
changes, holding utility constant.
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Compensated Demand Curves

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Compensated & Uncompensated
Demand

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Compensated & Uncompensated
Demand
• For a normal good, the compensated demand curve
is less responsive to price changes than is the
uncompensated demand curve
–the uncompensated demand curve reflects both
income and substitution effects
–the compensated demand curve reflects only
substitution effects

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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”.

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1) Changes in a Good’s Price:
Price of X ↓

Suppose the consumer is initially

maximizing utility at point A.
If the Px ↓, the consumer will maximize
utility at point B.

Total Effect or Price Effect =AB

i.e the change in Qx

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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,
at the new prices, s/he can just afford to buy the original
bundle?”

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THE SLUTSKY METHOD
• To isolate the
substitution effect we
adjust the 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 new optimum on I3
is at Ec. The movement
from Ea to Ec is the
substitution effect
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THE SLUTSKY METHOD for NORMAL
GOODS

The income and

substitution effects
reinforce each other.

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THE SLUTSKY METHOD: INFERIOR
GOODS

• The substitution
effect is as per usual.
• But, the income
effect is
in the opposite
direction.

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THE SLUTSKY METHOD for INFERIOR
GOODS (Giffen goods)
• In rare cases of extreme
income-inferiority, the
income effect may be
larger in size than the
substitution effect,
causing quantity
demanded to fall as
own-price falls.

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 BITS Pilani
Pilani Campus

Income and Substitution Effects

Prof. Geetilaxmi Mohapatra40
SE and IE using Hicks and Slutsky
method for Normal goods : When PX ↓ses

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SE and IE using Hicks and Slutsky
method for Inferior goods: When PX ↓ses

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SE and IE using Hicks and Slutsky
method for Giffen goods: When PX ↓ses

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 Consumer Welfare
• We often want to measure how consumers’ welfare is
affected by changes in the economic environment.
• E.g: a change in the price, or a change in governmental
policy
• Policy makers may want to have quantifiable monetary
measures of changes in welfare.
• Such measures would allow them to, rank-order different
policy changes or to compare benefits and costs to different
groups of consumers.

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 Measures of Consumer Welfare
• Q: Should we use the compensated demand curve for
the original target utility (U0) or the new level of utility
after the price change (U1)?
• 3 important measures of consumer welfare
• 1) Compensating Variation (CV)
• 2) Equivalent Variation (EV)
• 3) Changes in Consumer Surplus (∆ CS)

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Consumer Welfare:
1) Compensating Variation

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Consumer Welfare:
Compensating Variation for increase in Px

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Compensating Variation
• Compensates the consumer for a ↓ in real income as prices ↑ (or
vice versa)
• The new budget constraint is pulled back (parallel) to the original IC

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Equivalent Variation

The amount by which nominal income would have to change to be equivalent

to the effect of the price change
The old budget constraint is moved (parallel) to the new IC

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 BITS Pilani
Pilani Campus

Income and Substitution Effects

Prof. Geetilaxmi Mohapatra50
 Measures of Consumer Welfare
• Q: Should we use the compensated demand curve for
the original target utility (U0) or the new level of utility
after the price change (U1)?
• 3 important measures of consumer welfare
• 1) Compensating Variation (CV)
• 2) Equivalent Variation (EV)
• 3) Changes in Consumer Surplus (∆ CS)

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CV and EV for a ↑ in the PX (or good 1)

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CV and EV for a ↓ in the PX

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Measurement of Consumer Welfare
A price change generally involves both IE and SE
Q: should we use the compensated demand curve for the original target utility
(U0) or the new level of utility after the price change (U1)?

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Consumer Surplus

We will define consumer surplus as the area

below the Marshallian demand curve and above
the prevailing market price
–changes in consumer surplus measure the
welfare effects of price changes

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Marshallian Demand Elasticities

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Price Elasticity of Demand

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Hicksian Compensated Price Elasticities

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The Slutsky Equation

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Price Elasticities

The Slutsky equation shows that the

compensated and uncompensated price
elasticities will be similar if
–the share of income devoted to x is small
–the income elasticity of x is small

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 Revealed Preference Hypothesis
• The theory of revealed preference was proposed by Paul A. Samuelson in
“Consumption Theory in Terms of Revealed Preference”, in the year 1948.
• Paul Anthony Samuelson (1915-2009) was an American economist, the
first American to win the Nobel Prize in Economic Sciences in 1970.
• Considered major breakthrough in the theory of demand .
• It establishes law of demand without using Indifference Curve and their
respective assumptions.
• Assumptions:
– 1) Rationality
– 2) Consistency
– 3) Transitivity
– 4) Revealed Preference axiom
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Revealed Preference Axiom

• Consider two bundles of goods: A and B

• If the individual can afford to purchase either bundle
but chooses B, we say that B had been revealed
preferred to A
• The chosen basket B maximizes (axiomatically) his
utility and rest of the baskets on the budget line are
revealed inferior.

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Revealed Preference Hypothesis:
Derivation of Demand Curve

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Weak Axiom of Revealed Preference
(WARP)
• If bundle (x1, y1) is directly revealed preferred to
bundle (x2, y2), the two bundles being different from
each other, it cannot happen that bundle (x2, y2)
would be directly revealed preferred to bundle (x1,
Y1).
• That is: If (x1,y1) is revealed preferred when (x2,y2)
was affordable then (x1,y1) is preferred always (or at
all prices).

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Strong Axiom of Revealed Preference

• If commodity bundle 0 is revealed preferred to bundle 1, and

if bundle 1 is revealed preferred to bundle 2, and if bundle 2
is revealed preferred to bundle 3,…, and if bundle K-1 is
revealed preferred to bundle K, then bundle K cannot be
revealed preferred to bundle 0

• SARP is a necessary and sufficient condition for observed

behaviour to be consistent with the underlying model of
consumer choice
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 BITS Pilani
Pilani Campus

Income and Substitution Effects

Prof. Geetilaxmi Mohapatra66
 Revealed Preference Hypothesis
• The theory of revealed preference was proposed by Paul A. Samuelson in
“Consumption Theory in Terms of Revealed Preference”, in the year 1948.
• Paul Anthony Samuelson (1915-2009) was an American economist, the
first American to win the Nobel Prize in Economic Sciences in 1970.
• Considered major breakthrough in the theory of demand .
• It establishes law of demand without using Indifference Curve and their
respective assumptions.
• Assumptions:
– 1) Rationality
– 2) Consistency
– 3) Transitivity
– 4) Revealed Preference axiom
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Revealed Preference Axiom

• Consider two bundles of goods: A and B

• If the individual can afford to purchase either bundle
but chooses B, we say that B had been revealed
preferred to A
• The chosen basket B maximizes (axiomatically) his
utility and rest of the baskets on the budget line are
revealed inferior.

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Revealed Preference Hypothesis:
Derivation of Demand Curve

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Weak Axiom of Revealed Preference
(WARP)
• If bundle (x1, y1) is directly revealed preferred to
bundle (x2, y2), the two bundles being different from
each other, it cannot happen that bundle (x2, y2)
would be directly revealed preferred to bundle (x1,
Y1).

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Strong Axiom of Revealed Preference

• If commodity bundle 0 is revealed preferred to bundle 1, and

if bundle 1 is revealed preferred to bundle 2, and if bundle 2
is revealed preferred to bundle 3,…, and if bundle K-1 is
revealed preferred to bundle K, then bundle K cannot be
revealed preferred to bundle 0

• SARP is a necessary and sufficient condition for observed

behaviour to be consistent with the underlying model of
consumer choice
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 BITS Pilani
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Demand Relationship among the Goods

Prof. Geetilaxmi Mohapatra72

 The Two-Good Case

• The types of relationships that can occur when

there are only two goods are limited.
• Either it can
• Complements
• Substitutes

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The Two-Good Case

When the Py falls, the substitution

effect may be so small that the
consumer purchases more Y
and more x

In this case, we call x and y gross

complements

x/py < 0 (negative)

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The Two-Good Case

When the price of y falls, the

substitution effect may be so
large that the consumer
purchases less x and more y

In this case, we call x and y gross

substitutes

x/py > 0 (positive)

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 Substitutes and Complements

Two goods are substitutes if one good may replace

the other in use
– E.g: tea & coffee

Two goods are complements if they are used

together
– E.g: coffee & cream

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Gross Substitutes and Complements

The concepts of gross substitutes and gross complements

include both SE and IE
– two goods are gross substitutes if
xi /pj > 0
– two goods are gross complements if
xi /pj < 0

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Net Substitutes and Complements

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 Substitutability with Many Goods
• Once the utility-maximizing model is extended to many goods, a wide variety of
demand patterns becomes possible
• According to Hicks’ second law of demand, “most” goods must be
substitutes
• To prove this, we can start with the compensated demand function
• xc(p1,…pn,V)
• Applying Euler’s theorem yields

xic xic xic

p1  + p2  + ... + pn =0
p1 p2 pn
• In elasticity terms, we get e + e + ... + e = 0
c
i1
c
i2
c
in

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 Substitutability with Many Goods

• In elasticity terms, we get eic1 + eic2 + ... + einc = 0

• Since the negativity of the SE implies that eiic  0, it must be
the case that

 ij  0
e c

j i

• The sum of all the compensated cross – price elasticities for

a particular good must be positive ( or zero).
• Thus most goods are substitutes.

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 Composite Commodity

• It is often convenient to group goods into larger aggregates

• E.g: food, clothing, “all other goods”
• A composite commodity is a group of goods for which all
prices move together
– these goods can be treated as a single commodity
• the individual behaves as if he is choosing between other
goods and spending on this entire composite group

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 Composite Commodity Theorem

• Suppose that consumers choose among n goods

• The demand for x1 will depend on the prices of the other n-1
commodities
• If all of these prices move together, it may make sense to
lump them into a single composite commodity (y)

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 Composite Commodity Theorem
Let p20…pn0 represent the initial prices of these other commodities
– assume they all vary together
Define the composite commodity y
y = p20x2 + p30x3 +…+ pn0xn
The individual’s budget constraint is
I = p1x1 + p20x2 +…+ pn0xn = p1x1 + y
If we assume that all of the prices p20…pn0 change by the same factor (t > 0)
then the budget constraint becomes
I = p1x1 + tp20x2 +…+ tpn0xn = p1x1 + ty
– changes in p1 or t induce substitution effects
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