7.

Income and Substitution

Effects
Varian, Chapter 8.

Decomposing the price change

Good X has a price pX = p; good Y has pY = 1
A reduction in p has two effects:
- it makes good X relatively less expensive
- it raises purchasing power

The total change in demand for good X can

be decomposed into a substitution effect and
an income effect

The price change

y
m

Decomposing the price change

y
m

Pivot:
Relative price
of good x falls

Decomposing the price change

(cont.)
y
m

B
Shift:
Purchasing power
increases

The change in purchasing power

Starting at A, the consumer can afford
more of both goods if the price of X falls
With money m, she can just afford her
original bundle, given the new prices
The change in purchasing power is
m-m = -Dpx0

Substitution and income effects

y

Demand for good X at C is

the compensated demand,
X(p,1,m)

m
A

Substitution effect

x
Income effect

Calculating the substitution effect

Suppose that demand for good X is
X(p,1,m) = m/(5p)
Initially, m = $120 and p = $3
Consumption of X is x0 = 8

Price of X falls to $2
Consumption of X rises to 12

Here m-m = -Dpx0 = 8

Substitution
effect is
11.2-8 = 3.2

Compensated demand is (120-8)/10 = 11.2

The substitution effect of a price

decrease is positive
y
m

m
A

Substitution effect

Calculating the income effect

The income effect is equal to the change
in demand accompanying a change in
money of m-m, at the new prices
In the example above, m-m = 8, so we
must find the effect of giving back $8
Income effect is
12-11.2 = 0.8

The income effect is positive for

a normal good
y

X is normal here, so the

total effect is positive

x
Income effect

The income effect is negative

for an inferior good
y

X is inferior here, but the

total effect is still positive

x
Income effect

Giffen good
A Giffen good has a
negative income effect,
with greater magnitude
than the substitution
effect

y
B

Income effect

Substitution effect

Perfect complements
y

Original budget
B
A

New budget
x
Shift

Pivot

Perfect substitutes
y

A
Original budget

New budget

Pivot

Quasi-linear preferences
y

B
A

Pivot

Shift

Tax policy: Estate tax

GU

A
C

m(1t)

children

Tax policy: a tax and a rebate

Per-unit tax on good X at rate t
Give a lump-sum refund to the consumer
If the refund equals the amount of tax
paid, she consumes less of good X and is
worse-off than without the tax and rebate

Tax policy: a tax and a rebate

y

A
Budget line
without tax

Budget line with

tax and rebate

An example
Let utility be u(x,y) = xy
Prices are pX = pY = 1; money is m = 12
X(1,1,12) = Y(1,1,12) = 6
Utility is u(6,6) = 36

10

An example (cont.)
Now consider a per-unit subsidy on good
X of s = and a lump-sum tax of T = 4
X(,1,8) = 8, Y(,1,8) = 4
Utility is u(8,4) = 32

Real time pricing (RTP)

Demand for electricity varies with the
weather, but retail prices tend not to vary
Several power companies have optional
RTP programs for large customers that let
prices vary with aggregate demand

11

RTP (cont.)
Money spent
on other goods

Baseline budget line

Electricity

RTP budget line

Hicksian Decomposition
y
m

A
B
C

12