Extensions of consumer theory: substitution and income effects

In practice, a price change generally affects you 2 ways. It affects the relative attractiveness of related goods, and it changes your attainbale level of well-being (your utility).

Both affect consumption of the good whose price has changed.
--1. Consumption will adjust because of the new optimal value for MRS
--2. Consumption will adjust because of the new level of well-being

(1) The substitution effect: the consumption adjustment you make because the new price changes the relative attractiveness of the goods you buy.
(=> move to new P on original U)

Ex: A lower relative price (of health food=goodX) makes you tend to substitute health food for junk food (goodY).
Makes the new BL flatter than before, so you move to a flatter part of any indifference curve you might be on

(2) The income effect: the consumption adjustment you make because the new price changes your attainable level of well-being.
(=> move to new U at new price)

For example, when price falls, your greater sense of well-being prompts you to change your consumption of health food.

Example: you consume two goods:
Health food (H) and
Junk food (J)

(Give Ua a smooth gradual sweep; this helps to illustrate the two effects clearly.)

    Now consider what happens when the price of health food (Ph) falls, moving consumption to point 'b'.
    (To allow plenty of room to work, note that (1) Ph falls quite a bit, and (2) point 'b' is pretty far over to the right of point 'a'.)
    (Make Xb = 8)

(1) THE SUBSTITUTION EFFECT isolates the consumption adjustment you make because the new price changes the relative attractiveness of the goods you buy.
(It shows your consumption at the new price but at your original utility.)

To find the substitution effect, draw BLa' by sliding BLb back until it is tangent to Ua. (Label the tangency point as a'; Make Xa'=6)

(2) THE INCOME EFFECT is the consumption adjustment you make because the new price changes your attainable level of well-being.
(It shows what happens to consumption as you move to a new indifference curve at the new price)

Key results: The substitution effect always makes us consume more of a good when it gets cheaper and less of it when it gets more expensive. It's the pure version of the 'law of demand'.
The income effect of a lower price makes consumption rise for a normal good but fall for an inferior good.

Substitution effect: large when good substitutes are available.
string beans and lima beans

Income effect: large when the budget share of the product is high.
housing, staple foods for the poor

Good counterexample: salt
No good substitute and a small budget share. Both effects are small, so demand for salt is very inelastic.

Failure to separate substitution and income effects can lead to some counterintuitive results.

(1) Upward sloping demand curves (Giffen goods)--How substitution and income effects influence consumer demand:

The substitution effect always makes quantity demanded rise when price falls and vice versa.
But the demand curve includes both substitution and income effects.

For a normal good, the substitution and income effects reinforce each other.
So D will slope down

(available online: Substitution and income effects: alternative possibilities
Worksheet

? True or false: All Giffen goods are inferior goods, but not all inferior goods are Giffen goods.

    Recap:
    Necessary conditions for a Giffen good:
    1. Inferior good
    2. Few subs (=> small sub effect)
    3. Large budget share (=> large inc effect)

    May be mainly academic, but possibly observed for rats:
    X= quinine water, healthy, but not liked
    Y= root beer
    P = lever pushes: 1 lever push for X, 2 lever pushes for Y
    I = total lever pushes, I held low, so rats were hungry.
    Lower Px = more X per push

    Recall, cross-price elasticities tell us whether goods are substitutes or complements.
    We know in fact that the distinction shows up in the shape of indifference curves, but in practice, when the price of one good changes, we don't stay on a single indifference curve.
     This can cause income and substitution effect problems.

Ex: Marie Antoinette

? Did Marie Antioinette consider bread and cake to be substitutes or complements?

?How did you decide?

    Let:
    X = Bread (B)
   Y = Cake (C)
and start with a relatively low price of bread.

Let the price of bread rise, and consider first the substitution effect.
? What do we do to show it?

But as utility falls due to the higher price of bread, consumers will move back down their income consumption curve to reach BLb, and the income effect will make cake consumption fall if cake is a normal good.

    Overall:
    1 = substitution effect, raising cake consumption.
    2 = income effect, lowering cake consumption.
    Combined: cake consumption can fall as the price of bread rises.

Substitute and complement goods actually refer just to the shape of indifference curves. 1 = perfect substitutes 2 = perfect complements 3 = strong substitutes 4 = strong complements Income effects can obscure these relationships when we try to observe them

	Normal good	Inferior good
Substitution effect:
Income effect:
Combined effects: