• Save
Microeconomics: Income and Substitution Effects
Upcoming SlideShare
Loading in...5
×
 

Microeconomics: Income and Substitution Effects

on

  • 125,547 views

Consumer Behavior: Income and Substitution Effects ...

Consumer Behavior: Income and Substitution Effects
The Consumer’s Reaction to a Change in Income
Engel Curve or Engel’s Law
The Consumer’s Reaction to a Change in Price
The Consumer’s Demand Function
Cobb-Douglas Utility Function
The Slutsky Substitution Effect
The Hicks substitution effect

Statistics

Views

Total Views
125,547
Views on SlideShare
125,407
Embed Views
140

Actions

Likes
52
Downloads
0
Comments
3

4 Embeds 140

http://scleoniyx.wordpress.com 93
https://tasks.crowdflower.com 44
http://www.slashdocs.com 2
https://twitter.com 1

Accessibility

Categories

Upload Details

Uploaded via as Microsoft PowerPoint

Usage Rights

© All Rights Reserved

Report content

Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

Cancel
  • Full Name Full Name Comment goes here.
    Are you sure you want to
    Your message goes here
    Processing…
  • may i save this powerpoint ???
    Are you sure you want to
    Your message goes here
    Processing…
  • The substitution effect is the change in consumption patterns due to a change in the relative prices of goods. For example, if private universities increase their tuition by 10% and public universities increase their tuition by only 2%, then it is very likely that we would see a shift in attendance from private to public universities (at least amongst students accepted to both). The same can be said across brands, goods, and even categories of goods.
    The income effect is the change in consumption patterns due to the change in purchasing power. This can occur from income increases, price changes, or even currency fluctuations. Since income is not a good in and of itself (it can only be exchanged for goods and services, a point which has been debated recently by neuroeconomists), price decreases increase one’s purchasing power.
    Are you sure you want to
    Your message goes here
    Processing…
  • The last table illustrating both effects for the different goods is really interesting -but how would such an illustration for a superior good differ from that of a normal one ?
    Are you sure you want to
    Your message goes here
    Processing…
Post Comment
Edit your comment
  • ITSF 4151. Special Topics in the Economics of Education: Microeconomic Aspects of Education Dr. Manuel Salas-Velasco

Microeconomics: Income and Substitution Effects Microeconomics: Income and Substitution Effects Presentation Transcript

  • Microeconomics Consumer Behavior: Income and Substitution Effects Dr. Manuel Salas Velasco
  • The Budget Constraint Dr. Manuel Salas Velasco vertical intercept horizontal intercept Slope The equation for the budget line: Relative price ratio Budget set The budget set consists of all bundles that are affordable at the given prices and income
  • The Consumer’s Utility Maximizing Choice Dr. Manuel Salas Velasco E
    • The consumer’s utility is maximized at the point (E) where an indifference curve is tangent to the budget line
    • The condition for utility maximization:
    X* Y* (X*, Y*) is the utility-maximizing bundle
    • The optimum quantities (X*, Y*) obtained by solving the Lagrangean problem tell us how much of each good an individual consumer will demand, assuming that he/she behaves rationally and optimizes his/her utility within his/her budget.
  • Consumer Behavior The Consumer’s Reaction to a Change in Income Dr. Manuel Salas Velasco
  • Shifts in the Budget Line Dr. Manuel Salas Velasco M’ = 20; P X = 2; P Y = 1 M = 10; P X = 2; P Y = 1 Prices are held constant and income increases (e.g. the consumer’s income doubles) M’ > M
  • Response to Income Changes Dr. Manuel Salas Velasco Y X Income-Consumption Curve E 1 E 2 E 3 X, Y, normal goods Prices are held constant Income increases: M 1 < M 2 < M 3
    • Increases in money income cause a parallel outward shift of the budget line
    • The utility-maximizing point moves from E 1 to E 2 to E 3
    • By joining all the utility-maximizing points, an income-consumption line is traced out
  • How Consumption Changes as Income Changes Dr. Manuel Salas Velasco M Y Engel Curve for good Y, with good Y as normal M 1 M 2 M 3
  • Engel Curve or Engel’s Law
    • A general reference to the function which shows the relationship between various quantities of a good a consumer is willing to purchase at varying income levels ( ceteris paribus )
    Dr. Manuel Salas Velasco Ernst Engel (1821-1896)
    • A German statistician who studied the spending patterns of groups of people of different incomes
    • People spent a smaller and smaller proportion of their incomes on food as those incomes increased
  • Consumer Behavior The Consumer’s Reaction to a Change in Price Dr. Manuel Salas Velasco
  • Shifts in the Budget Line Dr. Manuel Salas Velasco M = 10; P X = 2; P Y = 1 M = 10; P’ X = 1; P Y = 1 Decrease in the price of X (50%)
  • Response to Changes in a Good’s Price Dr. Manuel Salas Velasco Y X Price-Consumption Curve E 1 E 2 E 3 Decrease in the price of X: Price of Y and income are held constant: > >
  • How Consumption Changes as Price Ratio Changes Dr. Manuel Salas Velasco Quantity, X Price of X Demand Curve for X
  • The Consumer’s Demand Function Dr. Manuel Salas Velasco
    • We are interested in finding the individual demand curve for the good X; an expression for quantity demanded as a function of all prices and income
    • The condition for utility maximization is:
    U = U (X, Y)
    • Let’s suppose that the utility function is: U = X Y + X + Y
  • The Consumer’s Demand Function Dr. Manuel Salas Velasco P X X + P Y Y = M X = X (P X , P Y , M) Consumer’s demand function (generalized demand function)
  • The Own-Price Demand Dr. Manuel Salas Velasco M = $100; P Y = $10 Consumer’s demand function The own-price demand curve (ordinary demand function for X): X = f (P X ), ceteris paribus Suppose we use the following parametric values:
    • However, economists by convention always graph the demand function with price on the vertical axis and quantity demanded on the horizontal axis
    The inverse demand function P X X
  • The Engel Curve Dr. Manuel Salas Velasco P X = $5; P Y = $10 Consumer’s demand function The Engel curve for X If Income Elasticity is positive, then X is a normal good (quantity demanded increases as income increases, ceteris paribus ) Suppose we use the following parametric values: X is a normal good
  • The Cross-Price Demand Curve Dr. Manuel Salas Velasco P X = $5; M = $100 Consumer’s demand function Suppose we use the following parametric values: Cross-price demand curve for X
    • We hold the own price of good X and money income constant; we focus on the relationship between the quantity demanded of good X and the price of good Y
    If CPE is positive, then X,Y are substitutes If CPE is negative, then X,Y are complements X is a substitute for Y
  • Cobb-Douglas Utility Function Dr. Manuel Salas Velasco
    • The condition for utility maximization is:
    U = U (X, Y) P X X + P Y Y = M Consumer’s demand function for X
    • The utility function is:
    P X = 4; M = 800; P Y = 1 X* = 100 units
  • Consumer Behavior Income and Substitution Effects Dr. Manuel Salas Velasco
  • The Income Effect and the Substitution Effect of a Price Change Dr. Manuel Salas Velasco Quantity, X Price of X Own-Price Demand Curve for X (Inverse Ordinary Demand Function for X)
    • When price of good X falls, the optimal consumption level (or quantity demanded) of good X increases
    • What are the underlying reasons for a response in the quantity demanded of good X due to a change in its own price?
    • Substitution effect : the impact that a change in the price of a good has on the quantity demanded of that good, which is due to the resulting change in relative prices (P X /P Y )
    • Income effect: the impact that a change in the price of a good has on the quantity demanded of that good due strictly to the resulting change in real income (or purchasing power)
    Total effect
  • Income and Substitution Effects Dr. Manuel Salas Velasco Y X Price of Y and monetary income are held constant: Decrease in the price of X: > E 1 E 2 TE SE total effect (TE) = substitution effect (SE) + income effect (IE) IE
  • The Substitution Effect: Two Definitions in the Literature Dr. Manuel Salas Velasco Eugene Slutsky 1880-1948 Sir John R. Hicks 1904-89 The Slutsky substitution effect The Hicks substitution effect The effect on consumer choice of changing the price ratio, leaving his/her initial utility unchanged The effect on consumer choice of changing the price ratio, leaving the consumer just able to afford his/her initial bundle
  • The Slutsky Substitution Effect Dr. Manuel Salas Velasco Y X Price of Y and monetary income are held constant: Decrease in the price of X: > E 1 E 2 E 3
    • We do this by shifting the line AB to a parallel line CD that just passes through E 1 (keeping purchasing power constant)
    • To remove the income effect, imagine reducing the consumer’s money income until the initial bundle is just attainable
    A B C D
    • Although is still affordable, it is not the optimal purchase at the budget line CD
    • The optimal bundle of goods is:
    SE IE TE X is a normal good
  • The Slutsky Substitution Effect Dr. Manuel Salas Velasco Y X E 1 E 2 E 3 A B C D E 1 : Change ( reduction ) in money income necessary to make the initial bundle affordable at the new prices M’= amount of money income that will just make the original consumption bundle affordable: E 3 : SE IE TE X is a normal good
  • Example Dr. Manuel Salas Velasco
    • The individual demand function for milk is:
    • Consumer’s income is $120 per week and P X is $3 per quart:
    • Let’s suppose that the price of milk falls to $2 per quart:
    • The total change (total effect):
    Level of income necessary to keep purchasing power constant
    • The substitution effect is:
    • The income effect is: 0.7 (16 – 15.3)
  • The Hicks substitution effect Dr. Manuel Salas Velasco Y X > E 1 E 2 E 3
    • To remove the income effect, imagine reducing the consumer’s money income until the initial indifference curve is just attainable
    • We do this by shifting the line AB to a parallel line CD that just touches the indifference curve U 1 (the utility level is held constant at its initial level)
    A B C D SE IE TE
    • The intermediate point E 3 divides the quantity change into a substitution effect (SE) and an income effect (IE)
    X is a normal good
  • Income and Substitution Effects: Inferior Good Dr. Manuel Salas Velasco E 1 E 2 E 3 Y X > A B C D substitution effect income effect total effect
    • The consumer is initially at E 1 on budget line AF
    F
    • With a decrease in the price of good X, the consumer moves to E 2 ; the quantity of X demanded increases (total effect)
    • The total effect can be broken down into:
    • A substitution effect (associated with a move from E 1 to E 3 )
    • An income effect (associated with a move from E 3 to E 2 )
    X is an inferior good
    • The substitution effect exceeds the income effect, so the decrease in the price of good X leads to an increase in the quantity demanded
  • Income and Substitution Effects: The Giffen Good Dr. Manuel Salas Velasco E 1 E 2 E 3 Y X > A B C D substitution effect income effect total effect
    • The consumer is initially at E 1 on budget line AF
    F
    • With a decrease in the price of good X, the consumer moves to E 2 ; the quantity of X demanded decrease (total effect)
    • The total effect can be broken down into:
    • A substitution effect (associated with a move from E 1 to E 3 )
    • An income effect (associated with a move from E 3 to E 2 )
    X is a Giffen good
    • The income effect exceeds the substitution effect, so the decrease in the price of good X leads to a decrease in the quantity demanded
  • Income and Substitution Effects of a reduction in price of good X holding income and the price of good Y constant Dr. Manuel Salas Velasco Good X is: Substitution effect Income effect Total effect Normal Increase Increase Increase Inferior (not Giffen) Increase Decrease Increase Giffen (also inferior) Increase Decrease Decrease