Micro 2: Individual/Consumer choice - 2

1. Introduction

In a world of two goods, X and Y.. Consider the effects when price of X decreases.
decrease

• Following the price of X decreases, a whole new range of opportunities which

were not feasible to the individual before now are available.

• If the individual's Nominal income (or money income) does not change, the fall in
price of X means that there is a rise in his/her Real income.

• Given that individuals live in a two-goods

two goods world, a change in the price of X will
therefore generate
ate a change in the demand for Y too.

• The question
uestion we would like to ask is: How will the effects of the change in the
price of X be distributed
stributed between the two goods?

2. Real income

• Nominal Income is Money income in Dollar terms.

• Real income is not in terms of Dollar amount, there are two definitions of Real
Income.

• One is measured in terms of Utility (this is Hicksian definition of real income)

income).

• The other is measured in terms of the individual’s ability to buy the initial bundle
(this is Slutskian definition of real income).

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• Following the change in price of X, there are two effects that will affect
individual’s choice. They are:

(i) Substitution Effect

(ii) Income Effect

The combination of these two effects will determine the individual’s new choice
of consumption.

3. Hicksian Definition

• According to Hicks, the real income is measured in terms of utility.

• The substitution effect can be established by looking at the individual's optimal

choice if he/she confronted the new relative price while keeping utility
at the initial level.

• This can be achieved by finding the point of tangency of the new relative price
with the initial indifference curve.
y

I0
Py0

CH B

S.E.H I.E.H
U1
U0

x0 xC I0 x1 I0 x
Px0 Px1

• When price of X decreases, the move from A to C is called a Hicksian substitution

effect.

• Given Hicksian definition of real income at both A and C, the individual achieves
the same level of real income.

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• Note: Substitution effect is always inversed to price change, i.e, when price
decrease, we have positive substitution effect and vice versa.

• This is because the indifference curve is convex. Further, as price of x decreases,

the individual will rationally buy more of X because now X is cheaper.

• The move from C to B is called the income effect. This can be brought about by a
parallel shift of the Hicksian imaginary budget line.

• Such a shift can be thought as an increase in nominal income between points C

and B. We call the move from C to B as Income Effect.

• From point C to point B, individual move to a higher level of utility.

• If price remains at the same level, such an increase in utility can only be brought
about by an increase of Nominal Income.

• However, decrease in price of X make such an increase in utility possible without

any increase of Nominal Income.

• The movement from point A to point B is called the Total Effect following the
change in price of X. It is the sum of the Substitution Effect and the Income
Effect.

Exercise:
In a world of two goods x and y, examine both Hicksian Substitution and Income
effect, when price of X increases while price of Y remains at the same level. Is there
an inverse relationship between price and substitution effect?

I0
Py0

U0

I0 x I0 x
0
Px1 Px0

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Application using Hicksian approach:

If the price of x is 10 and the price of y is 5, an individual chooses to consume 80

units of y and 30 units of x (there are no other goods in the economy). When the price
of x falls to 5, substitution effect (based on Hicksian definition of real income) leads
the individual to choose a bundle of 50 units of x and 50 units of y. If the government
reduced this individual's income by 190, he will be as well off as before the change in
the price of x. True or false, explain.

y
I0 700
=
Py0 5

80 A

50 C

U0

50 I0 700 I0 700 x
30 = =
Px0 10 Px1 5

Initially, the individual chooses point A. His income is 700 and A is on the old budget
line. This can be seen as

Px0x0 + Py0y0 = 10 × 30 + 5 × 80 = 700

When the price of x falls to 5, substitution effect (based on Hicksian definition of real
income) leads the individual to choose a bundle of 50 units of x and 50 units of y.
This is point C on the Hick’s hypothetical budget line. The income necessary to
achieve the choice is 500.

Px1x1 + Py0y1 = 5 × 50 + 5 × 50 = 500

On point C, the individual is as well off as on point A.

This means that at the new price of x, the individual would need only 500 to be
indifferent between his new choice at C and the original choice at A.

His actual income is 700. If the government taxes 190 away from the individual, the
individual is better off.

The statement is therefore false.

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4. Slutskian Definition

• The measure for real income is in terms of the individual’s ability to buy the
initial bundle.

• If the individual is able to maintain the initial bundle at the new

price, we should observe a budget line that goes through point A. This
is an imaginary budget line according to Slusky’s analysis.

I0
Py0

S.E.S I.E.S
U1
U0

x0 xC I0 x I0 x
1
Px0 Px1

• However, point A does not maximize the individual’s utility at the new price. The
individual will hence chose a different point, point C, that maximizes his/her
utility.

• The move from point A to point C is called Slutskian Substitution Effect.

• The move from C to B is called the income effect. This can be brought about by a
parallel shift of the Slutsktian imaginary budget line.

• Such a shift can be thought as an increase in nominal income between points C

and B. We call the move from C to B as Income Effect.

• From point C to point B, individual move to a higher level of utility.

• If price remains at the same level, such an increase in utility can only be brought
about by an increase of Nominal Income.

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• However, decrease in price of X make such an increase in utility possible without
any increase of Nominal Income.

• The movement from point A to point B is called the Total Effect following the
change in price of X. It is the sum of the Substitution Effect and the Income
Effect.

Exercise:
In a world of two goods X and Y, examine both Slutsky’s Substitution and Income
effect, when price of X increases, while price of Y is held constant. Is there an inverse
relationship between price and substitution effect?

I0
Py0

U0

I0 x I0 x
0
Px1 Px0

5. Normal, Inferior and Giffen Goods

• When a good is a normal good, the income effect is positive. When the good is
an inferior good, the income effect is negative. The above definition has
implications on the individual’s demand.

• For instance, when the individual has higher nominal income, would he or she go
on overseas holiday more often? Would he or she consume more or less of bread?

• The answer to the above depends on the nature of the good. More specifically,

1) Normal Good: if income increases, the quantity demanded for the good
increases; if income decreases, the quantity demanded for the good decreases.

2) Inferior Good: if income increases, the quantity demanded for the good
decreases; if income decreases, the quantity demanded for the good increases.

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• Graphically, when income increases, the new choice should be on the right of A if
X is a normal good. If X is an inferior good, the new choice should be on the left
of A.

y x Inferior x Normal
I1
Py0
I0
BI
Py0

A BN

Px0
U0
Py0
x1 x0 x1 I0 I1 x
Px0 Px0

Exercise:
Find the new optimal choice following a decrease in individual’s income if X is a
normal good. What if X is an inferior good?

y
I0
Py0
I0 > I1

Px0
U0
Py0
x0 I0 x
Px0

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Now we look at the case of a decrease in price of X.

I0 X Inferior X Normal
Py0

CH

S.E.H
U0

x0 xC I0 I0 x
Px0 Px1

• A to C is the Hicksian Substitution Effect. C to B is the Hicksian Income Effect.

• B can be anywhere on the new budget line where utility is higher. However, there
are now two main possibilities.

1) The individual moves to the right of point C means that as income increases
the individual will want to consume more of X. Here, we call X is a Normal
Good.

2) If the individual will choose to be on the left of C means that as income

increases the individual will want to consume less of X. Here, we call X is an
Inferior Good.

• But what are the Giffen Goods? To qualify as a Giffen good, the choice of
individual must reveal two characteristics.

1) The good is an Inferior Good.

2) The substitution effect is smaller than the income effect.

• Following this definition, if the good is Giffen, then point B is on the left of A.
The fall in price of X results in a fall in the quantity demanded from the
individual.

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Exercise:
Find the new optimal choice following an increase in the price of X and is X is a
normal good. What if X is an inferior good?

I0
Py0

U0

I0 x I0 x
0
Px1 Px0

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6. Deriving the Demand Curve

I0 X Inferior X Normal
Py0 BG

BI
A

BN
CH

I .E.G
I .E.I
S.E. I.E.N
U0

x0 xC I0 I0 x
Px0 Px1

• The demand for a normal good will tend to be flatter than the demand for an
inferior good.

• The demand for an inferior good where the net-substitution effect is more
dominant is still downward sloping

• The demand for an inferior good where the income effects is more dominant (a
Giffen good) is upward sloping.

• The demand curve commonly observed tend to be downward slopping. That is,
the quantity demanded rises as the price of the product falls. This downward
slopping property of the demand curve is often called the Law of Demand.

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Exercise
1. Show that an increase in individual income shifts the demand curve to right if the
good is a normal good.

y
I1 X Normal
PY0

I0
Py0

BN
A

U0

x0 xC I0 I1 x
Px0 Px0

2. Show that an increase in individual income shifts the demand curve to left if the
good is an inferior good.

y
I1 X Inferior
PY0

I0 BI
Py0

U0

x0 xC I0 I1 x
Px0 Px0

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Exercises:
1) In one graph, examine both Hick’s and Slutsky’s definitions of Substitution effect
and Income effect when Px decreases and x is a Normal good. Compare the size of
Substitution and Income effects under the two different definitions.

I0
Py0

CH

S.E.H U0

x0 I0 I0 x
xCH
Px0 Px1

2) In one graph, examine both Hick’s and Slutsky’s definitions of Substitution effect
and Income effect when Px decreases and X is a Inferior good. Compare the size
of Substitution and Income effects under the two different definitions.

I0
Py0

CH

S.E.H U0

x0 I0 I0 x
xCH
Px0 Px1

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3) In one graph, examine both Hick’s and Slutsky’s definitions of Substitution effect
and Income effect when Px increases and X is a Normal good. Compare the size of
Substitution and Income effects under the two different definitions.

I0
Py0

CH

U0
S.E.H

I0 x I0 x
xCH 0
Px1 Px0

4) In one graph, examine both Hick’s and Slutsky’s definitions of Substitution effect
and Income effect when Px increases and X is a Inferior good. Compare the size of
Substitution and Income effects under the two different definitions.

I0
Py0

CH

U0
S.E.H

I0 x I0 x
xCH 0
Px1 Px0

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 The answer for the above questions are summarized in the following two tables,

Price of x decreases Substitution Effect Income Effect

Normal S>H S<H
Inferior S< H S<H

Price of x increases Substitution Effect Income Effect

Normal S<H S>H
Inferior S>H S>H

7. Complements and Gross Substitutes

• In the world of two goods, whenever we make decisions about the choice of one
good we are also deciding the choice of the other good. That is, the demands for
the two goods are interrelated.

• The interrelationship between the two goods is based on whether the two goods
are complement or gross substitute.

• Consider again the fall in the price of X, let us see what happens to the quantity
demanded of Y.

I0
Py0

x and y are Complement

B
y1
A
y0
U1

U0
x0 x1 I0 I0 x
Px0 Px1

There are two possibilities.

1) In the case where the consumption of Y increases when the price of X falls we say
that X and Y are complements.

• It is so because a fall in the price of X suggests that people will buy more of X.

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• If at the same time they also buy more of Y it must mean that individuals feel that
consumption of X 'goes well' with Y.

• For example, as the price of coffee falls, people tend to drink more coffee and
consume more sugar at the same time.

2) In the case where the consumption of Y falls with the fall in the price of X we
say that X and Y are gross substitutes. (We use 'gross' to distinguish it from the
substitution which we discussed before)

• A fall in the price of X suggests that we will consume more of (X is now cheaper).

• If consuming more of X means consuming less of Y, it must be that we feel that

we can substitute X for Y.

• For instance, when the price of coffee decreases, people will tend to drink more
coffee and drink less tea instead. Mathematically, we thus have:

∂y d
y
ε xy = > 0 if X and Y are Gross Substitute(e.g., coffee and tea).
∂px
px
d
∂y
y
ε xy = < 0 if X and Y are Complements(e.g., entertainment and food).
∂px
px

Exercise:
1) Establish point B following an increase in price of X when X and Y are
complement. What if X and Y are gross substitute?

I0
Py0

A
y0

U0

x0 I0 I0 x
Px1 Px0

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2) If good X and Y are complement, what would happened to the demand curve for
good Y if price of X falls?

I0
Py0

x and y are Complement

B
y1
A
y0
U1

U0
x0 x1 I0 I0 x
Px0 Px1

3) If good X and Y are gross-substitute, what would happened to the demand curve
for good Y if price of X falls?

I0
Py0

A
y0

y1 B x and y are Gross Substitute

U1

U0
x0 I0 I0 x
x1
Px0 Px1

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8. Income in-kind

y
I0
Py0

y0 A

U0

y E

y0 ' A’

U0 '
x0 x0 ' I0 x
x
Px0

• Individual is given income in-kind of x units of X and y units of Y at point E.

• Selling x of X and y of Y at the prices of p x0 and p 0y , the individual obtains

income of
I 0 = Px0 x + Py0 y

• With income of I 0 , the individual can choose a point like A or A’ on the budget
line that maximizes his/her utility.

• Suppose price of X decreases, the individual’s new budget line would rotate point
E and becomes flatter.

• If the individual’s initial choice of X is more than x and X is normal, the demand
for X can only be downward slopping.

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 y
I0 X Inferior X Normal
Py0

I1
Py0

y E

A
y0
C
BN
U1 Note:
U0

x0 I0 N I1 x
x x1
Px0 Px1

• If the individual’s initial choice of X is less than x and X is normal, the demand
for X can either be downward slopping or upward slopping.

y
I0 X Normal X Inferior
Py0

y0 A
I1
Py0 BN
C
N
B
U0
E
y
Note:

I0 I1 x
x1N x0 x1N x
Px0 Px1

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9. Demand Price Elasticity

• What happen to firms' revenue or consumers' spending if the price of X decreases

(or, increases)?

• The answer for the above question depends on the degree of Demand Price
Elasticity for good X. Consider the following demand schedule for good X.

Px0 x0 = α + β ; Px1 x1 = β + γ
Px0 x0 > Px1 x1 ⇒ α + β > β + γ ⇒ α > γ
Px
α = dP × x; γ = dx × P

A
Px0
dP α B
Px1

β γ
Dx

x0 x1 x
dx

• At point A, the total spending on X is: Px0 x0 . This is also the firms' revenue.

• If the price of X falls to Px1 and the quantity demanded increased to x1. We are at
point B.

• At point B, total consumers' spending/firm’s revenue will now be Px1 x1

• Graphically, we can say that the total spending at point A is α + β and the total
spending at point B is β + γ .

• If revenue at A is greater than that of B, we say that when price decreases, the
consumer spends less on good X (or firm’s revenue from selling X decreases).
Graphically, this is equivalent to

α + β > β +γ or α >γ

• α is the area which depicts the loss of revenue on previous sales (or, from the
point of view of the consumer, the savings on previous purchases). Therefore, we
can write

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 α = dp ⋅ x

• γ represents the gains on the new sales (or the extra spending on the added
consumption). Hence,
γ = dx ⋅ p
• If α > γ , then
dP × x > dx × P
dx × P
⇔ 1>
dP × x
dx P dx / x
⇔ × = = η <1
dP x dp / p

• Thus, if η < 1 . Consumer spending or firms revenue decreases as price of X falls.

dx / x
• Defining demand price elasticity of good X as η = , price elasticity thus
dp / p
shows the relationship between the proportional change in quantity over the
proportional change in price.

• Demand price elasticity thus measures the percentage change in the quantity of a
good demanded that results from a 1 percent change in price.

• When η < 1, the proportional change in quantity (dx/x) is smaller than the
proportional change in price (dp/p).

• That is, if η < 1, consumer spending on X decreases as price of X falls; consumer

spending on X increases as price of X rises. Graphically, this can also be shown by
a steeper demand curve.

Demand Price Elasticity < 1 (Inelastic, e.g. Hair cuts)

Px

Px0 A

α
Px1 B

β γ
Dx
x0 x1 x

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• When η > 1, the proportional change in quantity (dx/x) is larger than the
proportional change in price (dp/p).

• When η > 1, consumer spending on X increases as price of X falls. Consumer

spending on X decreases as price of X rises. Graphically, this is shown as a flatter
demand curve.

Demand Price Elasticity > 1 (Elastic, e.g. Air tickets)

Px

A
Px0
α B
Px1

Dx
β γ
x0 x1 x

Exercise: Find the demand price elasticity for the following demand curves?

Px Px

Dx

Dx
x x

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 Example:
All points on the same demand curve have the same demand price elasticity, true
or false? Explain.

Px

A
Px0

Px1 B

Dx

x0 x1 x

dx p
• η = is the product of the inverse of the slope of the demand schedule and
dp x
the slope of the ray from the origin1. That is,

p 1
η =
x Slope of Demand Curve

• The slope of the demand curve at A and at B is exactly the same, ie., (dx/dp)A =
(dx/dp)B

• However, the rays from the origin to point A and B are different. (P/x)A > (P/x)B

A B
dx p dx p A B
• Therefore: × > × ⇔ η >η
dP x dP x

• This suggests that demand elasticity is diminishing as output increases.

• The statement is thus false.

• However, it is possible that all points on the same demand curve have the same
demand price elasticity if the demand curve is nonlinear. This class of demand
curve is called constant demand price elasticity demand curve.

Exercise:
What do you think a constant demand price elasticity demand curve will look like?

1
This way of finding demand price elasticity is called point-slope method.

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Homework

1. "Under Slutsky's definition of 'real income' the income effect is always smaller
than under the Hicksian definition of real income". True or false, explain.

2. When the income is given in kind, it is always possible for the demand for any of
the goods to be upward slopping even when the good is a normal good. T/F,
explain.

3. In a world of two goods, X and Y, a fall in the price of X implies that good X
must be an Inferior good if the price elasticity of demand for X is equal to unity.
True or false? Explain.

4. A consumer receive income in-kind of x and y . When price of X falls, show

I0 I
0
< 11 analytically using algebras.
Px Px

5. When the slope of the demand schedule (dp/dx) is (-1/2) and the price elasticity of
demand is (-1/2), the quantity demanded of the good must be twice the value of its
price. True or false, explain.

6. When demand function is linear, the demand curve is a straight line. Why is it true
that a flatter liner demand must come with a higher demand price elasticity than a
steeper demand?
p 1
Hint: η =
x Slope of Demand Curve

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