INCOME

and
SUBSTITUTION
EFFECTS
ECON 8500 – Iryna Dudnyk
RECALL THE PREVIOUS LECTURE:
• Utility is 𝑈 = 𝑞10.4 𝑞20.6 - `happiness` as a function of quantities

• MRS=2𝑞2 /3𝑞1 - value of good 1 in terms of good 2

• Ordinary demands: - how much consumer is willing to buy at

0.4𝑌 0.6𝑌
different prices given the income 𝑞1= ; 𝑞2=
𝑃1 𝑃2
• We will keep working with this utility function and demands
this lecture as well
 Consumers Respond to Changes in
Budget:
Suppose price of good 1 increases. For a consumer that means two
things:

• Good 1 becomes relatively more expensive – SUBSTITUTION

EFFECT – we substitute away from the goods that become relatively more
expnsive

• Real income falls – INCOME EFFECT – demand for goods increases or

decreases depending on the nature of the food (normal or inferior)

• To separate income and substitution effects we need new tools

INDIRECT UTILITY –’happiness’ as a function
of income and prices.
• Idea: when I know my budget I know what combination of
goods I am going to buy and, therefore, know how happy I will
be
• To find: plug ordinary demands into the utility function:
0.4𝑌 0.4 0.6𝑌 0.6
𝑈= 𝑞10.4 𝑞20.6 =
𝑃1 𝑃2

0.51𝑌
𝑈=
𝑃10.4 𝑃20.6
 Demo how indirect utility works:
In the previous lecture we worked with the following example:

𝒀 = $𝟏𝟎, 𝑷𝟏 = $𝟏, 𝑷𝟐 = $𝟏 optimal bundle A (4; 6)

Calculate utility in this bundle using utility f’n 𝑈 = 𝑞10.4 𝑞20.6 =

Now substitute income and prices into indirect utility:

0.51𝑌
𝑈= =
𝑃10.4 𝑃20.6
EXPENDITURE FUNCTION - income needed to
achieve (target) utility U given the prices
Idea: show consumer the prices and ask him: ‘Given these prices,
how much money do you need to achieve level of happiness = X?’
To find: isolate income from the indirect utility function:
0.51𝑌
𝑈=
𝑃10.4 𝑃20.6

𝑈𝑃10.4 𝑃20.6
𝑌= - will use this one a few times
0.51
Demo how expenditure function works:
We keep using the same example.

If 𝑷𝟏 = $𝟏, 𝑷𝟐 = $𝟏, how much money does the consumer need to

achieve utility level U = 5.1?

Substitute prices and utility number into the expenditure function:

𝑈𝑃10.4 𝑃20.6
𝑌= =
0.51
COMPENSATED DEMANDS – what
quantities are is purchased at different prices if
income is adjusted so that utility does not change

Idea: suppose price of good 1 increases. My budget ‘shrinks’

and I can no longer enjoy the bundle I was buying at the lower
price.
This means that now I am `not as happy` and my utility
decreases.

When we talk about compensated demands we give the

consumer income adjustment so that with the new higher price
he is as happy as before the price went up.
COMPENSATED DEMANDS cont’d
To find: substitute expenditure function for income into ordinary
demands:

𝑈𝑃10.4 𝑃20.6
𝑌=
0.51

0.4𝑌 0.4𝑼𝑷𝟎.𝟒
𝟏 𝑷𝟎.𝟔
𝟐
𝑞1= = =
𝑃1 𝑃1 ∗ 𝟎. 𝟓𝟏
0.6
𝑃2
𝑞1 = 0.78𝑈
𝑃1
COMPENSATED DEMAND for good 2
0.6𝑌 𝑈𝑃10.4 𝑃20.6
• 𝑞2= 𝑌=
𝑃2 0.51

0.6𝑌 0.𝟔𝑼𝑷𝟎.𝟒 𝑷𝟎.𝟔

• 𝑞2= = 𝟏 𝟐
=
𝑃2 𝑃2 ∗𝟎.𝟓𝟏

𝑃1 0.4
• 𝑞2 = 1.18𝑈
𝑃2
 FIND INCOME AND SUBSTITUTION EFFECTS
FOR THE FOLLOWING SCENARIO
Suppose initially 𝒀 = $𝟏𝟎, 𝑷𝟏 = $𝟏, 𝑷𝟐 = $𝟏. Then price of good 1
increases to 𝑷𝟏 = $2.

At first use Lagrange to find ordinary demands, indirect utility,

expenditure function, compensated demands. Then:
1. Find initial bundle, label A (4; 6) (we already found it last week)
2. Calculate utility in the initial bundle UA=5.1 (already did today)
3. Find terminal bundle:
0.4∗10 𝑐 0.6∗10
𝑞1𝑐 = =2; 𝑞2 = =6
2 1
Label C (2; 6)
As price of good 1 increased from $1 to $2 consumption of good 1
decreased from 4 to 2 units.

This change represents the TOTAL EFFECT = 𝒒𝑪𝟏 − 𝒒𝑨𝟏 = .

Obviously good 1 became relatively more expensive, substitute
away from it.
Last week when we discussed income-consumption curve for this
utility function we determined that good1 is a normal good.
Since real income decreased, less of good 1 is purchased.
To separate income and substitution effects we will use
compensated demands.
4. Find compensated bundle: substitute NEW prices and
ORIGINAL utility level into compensated demands.
Logic: we want consumer to only `think about` the relative price.
That is why we adjust his income so that he ‘does not feel better
or worse after the price changed’.
0.6 0.6
𝑃2 1
𝑞1𝐵 = 0.78𝑈 = 0.78 ∗ 5.1 =
𝑃1 2
0.4 0.4
𝑃1 2
𝑞2𝐵 = 1.18𝑈 = 1.18 ∗ 5.1 =
𝑃2 1

Check: 𝑈𝐵 =
SUBSTITUTION EFFECT - change in
consumption due to change in relative price,
keeping utility level fixed.
Represented by change in consumption from bundle A to B:

𝑆𝐸 = 𝑞1𝐵 − 𝑞1𝐴

𝑆𝐸 = =
Between bundles A and B:
utility remains the same (they are on the same IC)
Relative price of good 1 changes
INCOME EFFECT - change in
consumption due to change in real income.
Represented by movement from bundle B to C:

𝐼𝐸 = 𝑞1𝐶 − 𝑞1𝐵

𝐼𝐸 = =

Between these two bundles prices remain the same, only income
changes. The income adjustment is ‘removed’
Obviously, Total Effect = SE + IE
Final touch for the diagram:
Let’s calculate the compensated income:
Plug the NEW prices 𝑷𝟏 = $𝟐, 𝑷𝟐 = $𝟏 and the ORIGINAL utility
𝑼𝑨 = 𝟓. 𝟏 into expenditure function:
𝑈𝑃10.4 𝑃20.6
𝑌= =
0.51

At home check: if you plug compensated income and the

new prices into ordinary demands you will obtain bundle
B.
Initially 𝒀 = $𝟏𝟎, 𝑷𝟏 = $𝟏, 𝑷𝟐 = $𝟏 optimal bundle A (4; 6)
Then 𝒀 = $𝟏𝟎, 𝑷𝟏 = $𝟐, 𝑷𝟐 = $𝟏 optimal bundle C (2; 6)

q2
10

C A
IC0

IC’ BL0

BL’ q1
5 10
Add compensated BL: 𝒀 = $𝟏𝟑. 𝟐, 𝑷𝟏 = $𝟐, 𝑷𝟐 = $𝟏
𝟐𝒒𝟐
𝐌𝐑𝐒 =
𝟑𝒒𝟏
q2

B 2∗6
𝑀𝑅𝑆𝐴 4; 6 = =
3∗4
C A 2∗7.9
IC0 𝑀𝑅𝑆𝐵 2.6; 7.9 = =
3∗2.6

IC’ 2∗6
𝑀𝑅𝑆𝐶 2; 6 = =
3∗2
q1
Pay attention to:
• Bundles A and B are on the same indifference curve
• Compensated and new BL have the same slope (parallel).
• Indifference curves do not cross
• In all bundles indifference curves are tangent to the budget lines
• Label all intercepts
• Label all slopes
• CALCULATE and indicate MRS in all bundles (show your
work).
DIAGRAM: Ordinary and Compensated D’s
𝒀 = $𝟏𝟎, 𝑷𝟏 = $𝟏, 𝑷𝟐 = $𝟏
P
𝒀 = $𝟏𝟎, 𝑷𝟏 ` = $𝟐, 𝑷𝟐 = $𝟏

2 Ordinary Demand:
Total effect
0.4𝑌 𝟒
𝑞1 = =
𝑃1 𝑷𝟏
1 ’
Compensated
D Demand:
D SE only
2 4 compen q1
sated
 ORDINARY AND COMPENSATED
DEMANDS
Substitution effect is always negative: price and quantity change
in the opposite directions (with one exception)
Income effect depends on the good

For a normal good as price increases:

Real income falls => consumption falls
Income effect reinforces substitution effect:

Ordinary demand curve is flatter (more elastic) than compensated

demand curve
 IE and SE con’d
For an inferior good good as price increases:
Real income falls => consumption increases
Income effect ‘partially offsets’ the substitution effect:

Ordinary demand curve is steeper (inelastic) than compensated

demand curve.
Demands for Inferior Good:
𝒀 = $𝟏𝟎, 𝑷𝟏 = $𝟏, 𝑷𝟐 = $𝟏 𝑷′𝟏 = $𝟐,
P

2 B

1 A ’

q1
Giffen Good:
An inferior good such that income effect is larger than
substitution effect.
This will result in an upward-sloping demand curve.