Income and Substitution Effects: An In-Depth Analysis
Introduction
Income and substitution effects are fundamental concepts in economics, particularly in the field of microeconomics. They play a crucial role in understanding how consumers make choices when faced with changes in prices and income. These effects are essential in explaining consumer behavior and have widespread applications in various economic models and policy analysis. In this comprehensive exploration, we will delve into the income and substitution effects, elucidating their definitions, underlying theories, and real-world applications.
The Basics: Understanding Income and Substitution Effects
1.1. Income Effect
The income effect is a concept that pertains to the change in the quantity of a good demanded due to a change in consumer income, while keeping the prices of all other goods constant. In other words, it measures how a change in income affects the consumer's ability to afford goods and services. The income effect can be both positive and negative, depending on the nature of the good in question.
1.1.1. Normal Goods
For normal goods, an increase in income leads to a positive income effect, causing consumers to demand more of the good. Conversely, a decrease in income results in a negative income effect, causing consumers to demand less of the good.
1.1.2. Inferior Goods
Inferior goods exhibit an inverse relationship with income. When income rises, the income effect leads to a decrease in demand for inferior goods, while a decrease in income leads to an increase in demand for them.
1.2. Substitution Effect
The substitution effect is another pivotal concept that focuses on how changes in the relative prices of goods influence consumer behavior. It suggests that when the price of a good rises, consumers will substitute it with a cheaper alternative, assuming their income and preferences remain constant.
Analyzing Consumer Choices
2.1. The Price Consumption Curve
The Price Consumption Curve is a graphical representation that illustrates how a consumer's optimal choice changes as the price of a good changes while keeping the consumer's income constant. It is constructed by plotting the optimal bundles of goods for different price levels. The slope of the curve indicates the substitution effect, while the movement along the curve reflects the income effect.
2.2. The Engel Curve
The Engel Curve is another graphical tool used to explore the relationship between income and the quantity demanded of a particular good. It illustrates how the quantity of a good demanded changes as a consumer's income changes, holding all other factors constant. This curve can reveal whether a good is normal or inferior and provide insights into how consumer preferences evolve with changes in income.
Theoretical Frameworks
3.1. Indifference Curve Analysis
The income and substitution effects are closely tied to the concept of indifference curves. Indifference curve analysis provides a grap
2. Complete Budget as Group
• On Back of sheet answer the following
questions:
1. All rent prices drop $100.
a. Is this an increase in your income? Explain.
b. Would any of your decisions change?
Explain.
2. Uncle Jed passes on and creates a trust
fund for one of you increasing your
income 25% per month.
a. How much is your income now?
b. What different choices would you make?
3. Income Effects on Choices
in Output Markets
Income Effect- As income increases or as
the price of commonly purchased good
decreases, a household’s real income (or
overall buying power) increases.
Ex. Getting a Raise Getting Laid Off
National Fuel Raising Prices by 20%
Verizon cutting phone bills 33%
4. Income Effect
• When Income Rises, then Demand
increases = more buying power.
• When the price of goods that we buy often
is lowered, then we have more money (an
increase in a household’s real income). =
more buying power.
5. Substitution Effects on Choices
in Output Markets
• Substitution Effect- the idea that
households will buy more of the good or
service that costs less than its substitutes.
– What can I buy that gives me the most utility?
– When rent prices drop do I change to a
different apartment, substituting a bigger
apartment but now the same rent as before?
6. Income vs. Substitute Effect
Both the income and substitution effects imply a negative
relationship between price and quantity demanded – in
other words, downward-sloping demand. When the
price of something falls, ceteris paribus, we are better
off, and we are likely to buy more of that good and other
goods (income effect). Because lower prices also
means “less expensive relative to substitutes,” we are
likely to buy more of the good (substitution effect). When
the price of something rises, we are worse off, and we
will buy less of it (income effect). Higher price also
means “more expensive relative to substitutes,” and we
are likely to buy less of it and more of other goods
(substitution effect).
7. Consumer Surplus
• I am willing to pay $75 for the Tickle Me
Elmo. The store price for Elmo is $40. I
found Elmo at a store, how much money
did “save”?
• The difference between the maximum
amount a person is willing to pay for a
good and its current market price.
8. Consumer Surplus
• Consumer Surplus: is the amount that
consumers benefit by being able to
purchase a product for a price that is less
than they would be willing to pay
• Let’s Graph It!!
9. Consumer Paradox
• Adam Smith wrote about this phenomenon in
1776. In our consumer society we too often put
a high price on items that have little intrinsic
value and vice versa.
• Diamond/Water Paradox
• The things with the greatest value in use
frequently have little or no value in exchange
(water has no marginal utility).
• The things with the greatest value in exchange
frequently have little to no value in use (diamond
has a very large marginal utility)
