Lecture 9/10 - Income and Substitution effects Flashcards
How can we decompose the change in the quantity demanded of a good as its price changes?
We can decompose the change in the quantity demanded of a good into the substitution effect and the income effect
What is the substitution effect?
The substitution effect is when a consumer substitutes other goods for good A as the price of A rises
What is the income effect?
The income effect is when as the price of good A rises, real income falls and so spend on all goods changes
Look at the preferences diagram on slide 5 of lecture 10 and explain which parts of the total effect are the income and substitution effects
See slide 5 of lecture 10
What is the total effect of a change in the consumption of a good as price rises made up of?
Total effect = Substitution effect + Income effect
For a normal good, what is the income and substitution effect of an own-price increase?
The income and substitution effect of an own-price increase are both negative
For a normal good, what is the income and substitution effect of an own-price decrease?
For a normal good the income and substitution effect of an own-price decrease are both positive
For an inferior good, what is the income and substitution effect of an own-price increase?
For an inferior good subject to an own-price increase:
- The income effect is positive
- The substitution effect is negative
The total effect is negative
For an inferior good, what is the income and substitution effect of an own-price decrease?
For an inferior good subject to an own-price decrease:
- The income effect is negative
- The substitution effect is positive
The total effect is positive
What is a Giffen good?
A Giffen good has the following properties:
- When the price of the good increases, the positive income effect overcompensates the negative substitution effect so overall consumption increases
- When the price of the good decreases, the negative income effect overcompensates the positive substitution effect so overall consumption decreases
What are some examples of a Giffen good?
- The Irish Potato is the first example of a Giffen good
- Recent research by Jensen and Miller (2008) found that rice is a Giffen good in Hunan, China
What do standard demand curves reflect?
Standard demand curves reflect both income and substitution effects. These are also called uncompensated demand curves or Marshallian Demand curves
What is a compensated demand curve?
- A compensated demand curve holds utility constant as a good’s price changes
- It eliminates the income effect so price increases always decrease demand and price decreases always increase demand
What is a compensated demand curve also called
A Hicksian demand curve
What is an uncompensated demand curve also called?
A Marshallian demand curve
How do we construct a compensated demand curve?
We construct a compensated demand curve by shifting the budget constraints to remain on the same indifference curve
How is a compensated demand curve for normal goods different to regular demand curves for normal goods?
The compensated demand is steeper for normal goods because the income effect has been eliminated
Explain how to identify the income effect and the substitution effect on a preferences diagram as the price of a good increases
1- Find the original consumption point where the original budget constraint (L1) is tangent to the original indifference curve (I1) and label this e1
2- As the price of the good increases the consumer is compensated by raising their real income so the budget constraint now shifts up from L1 to L* and the new consumption point is where L* is tangent to I1 and we label this e*
3- To get the consumer’s actual choice we now shift the budget constraint lower than L1 and call this L2. We also shift the indifference curve downwards as well and label this I2. The final consumption point is where L2 is tangent to I2 and this point is labelled e2.
4- The substitution effect is the change from e1 to e*
5- The income effect is the difference between e* and e2
When the quantity demanded for a good decreases following an increase in its price, which comes first, the income or the substitution effect?
The substitution effect comes first and then the income effect comes after