Lecture 7-8 Substitution-Income Effect-Elasticity-Short

Lecture 7.
Substitution and Income Effects; elasticity
A. Banerji
August 27, 2023

Demand Curve: Own Price and Demand
In the consumer model, this translates to how a price change affects

Marshallian demand for a good.
A. Banerji Lecture 7. Substitution and Income Effects; elasticity August 27, 2023 2 / 52
Marshallian Demands:
Marshallian demands come from the bundle of goods that maximizes utility
on the budget set:
(x1∗ (p1 , p2 , m), x2∗ (p1 , p2 , m)) = argmax u(x1 , x2 ) on B(p1 , p2 , m)
For the record, also recall that the maximized utility as a function of prices
and income is called the indirect utility function:
v (p1 , p2 , m) = max u(x1 , x2 ) on B(p1 , p2 , m)
Demand curve
Response of x1 to change in p1 modelled as: what is the sign of

∂ x1∗ (p1 , p2 , m)/∂ p1 .
This is an own-price effect.
Sign of ∂ x2∗ (p1 , p2 , m)/∂ p1 is a cross-price effect.
Demand curve - own price effect
Is ∂ x1∗ (p1 , p2 , m)/∂ p1 < 0 so obvious?

No!

No!
For example, if p1 decreases, and you continue consuming the bundle you
were consuming, you have income left over.

No!
For example, if p1 decreases, and you continue consuming the bundle you
were consuming, you have income left over.
How do you spend this leftover income? If good 1 is a normal good, you
consume more of it if your income increases.
Income and Substitution Effect: Normal Good.
x2
x0∗ = h0∗
xn∗
hn∗
x1
SE1 IE1
Decomposing effect of price change
How to measure that you are richer even though m is unchanged, when p1
decreases?
One possibility: From the new situation, remove that amount of income
which will leave you at the original level of utility, when you were optimizing
before the price change.
This is Hicks’ ‘compensation’.
Alternatively, we could remove the amount of income which will permit you
to just buy your pre- price change bundle of goods. This is Slutsky
compensation.
Hicksian Demand
The picture was for Hicks compensation, which we focus on.

It shows the following: p1 decreases, swivelling the budget line; so, the price
ratio p1 /p2 decreases, but you are also richer in the sense of having income
left over at the original optimum.
At the new price ratio, reduce income (shift new budget line inwards), until
you are at a tangency with original max level of utility.
Notice that the consumption hjn1 of good 1 at this intermediate point is
∗ .
greater than the old consumption x01
This is the substitution effect: it is negative because the indifference curve is
downward sloping and strictly convex. It captures the pure effect of the
relative price change, on demand.
Decomposition - Substitution effect
Mathematically, write x2 = f (x1 ) for the indifference curve: so its slope

f 0 (x1 ) < 0, and curvature f 00 (x1 ) > 0. Starting at (x01
∗ , x ∗ ), a tangency when
02
price ratio is p1 /p2 , if good 1 price decreases to p10 < p1 , the slope p10 /p2 is
less negative than p1 /p2 . The new tangency at hn∗ on the same indifference
curve happens at a slope of f that is less negative: given f 0 < 0, f 00 > 0, this
happens at a higher x1 (and so lower x2 ).
Economically, suppose initially MRS(x∗0 ) = p1 /p2 = 1 and p10 /p2 = 1/2. At
the new price ratio, I can sell 1 of good 1 and buy 1/2 a unit of good 2; I can
sell 1 unit of good 2 and buy 2 units of good 1. Since MRS(x∗0 ) = 1, I am
indifferent when I give up 1 unit of good 2 and get 1 of good 1; but now the
market permits me to give up 1 unit of good 2 and get 2 units of good 1;
making me better off. So, I will substitute away from good 2 into more of
goodA. 1.
Banerji Lecture 7. Substitution and Income Effects; elasticity August 27, 2023 9 / 52
Decomposition - income effect
Note we say negative because the Hicksian demand increases as p1 decreases.

In ‘real’ terms, income has increased. If the pure effect of this is to increase
the demand for a good, we say the good is a normal good.
In the figure, the new Marshallian demand for good 1 is xn∗1 . Since
xn∗1 − hn∗ 1 > 0 happens as real income increases, the picture is that of a
normal good 1.
Decomposition
Substitution effect is always negative.
Decomposition
While income effect can be positive or negative.
Decomposition
For normal good

∂ xi∗ ∂ h∗ ∂ x ∗
= i − i xi∗ .
∂ pi ∂p ∂m
|{z}i | {z }
− +
Decomposition
For normal good

∂ xi∗ ∂ h∗ ∂ x ∗
= i − i xi∗ .
∂ pi ∂p ∂m
|{z}i | {z }
− +
For inferior goods

∂ xi∗ ∂ h∗ ∂ x ∗
= i − i xi∗ .
∂ pi ∂p ∂m
|{z}i | {z }
− −
Inferior Goods
If Marshallian demand for a good decreases as income increases, we call this

an inferior good.
Empirically, as incomes have increased with countries growing richer, we
notice consumption of some food items have fallen.
This is different from budget share on that food item being reduced: that has
happened for the food sector more generally with increase in incomes, and by
itself has led to some structural transformation in economies that have then
allocated more resources to producing manufacturing and services.
This is seen in the shrinking of the share of agriculture in GDP as a country
grows richer.
Income and Substitution Effect: Inferior Good.
x2
xn∗
x0∗ = h0∗
hn∗
IE1
x1
SE1
Giffen Goods:
Does, keeping all other factors fixed, quantity demanded always increase as
own price decreases, and decrease as own price increases?
It is definitely true for normal goods, but may not be true for inferior good as
∂ xi∗ ∂ h∗ ∂ x ∗
= i − i xi∗ .
∂ pi ∂p ∂m
|{z}i | {z }
− −
Inferior goods for which the income effect dominates the substitution effect
are called Giffen goods.
Giffen Goods:
x2
x0∗ = h0∗
hn∗
x1
SE1
Giffen Goods:
x2
xn∗
x0∗ = h0∗
hn∗
IE1
x1
SE1
Do Giffen Goods Exist in Reality?
Link
Jensen-Miller AER2008 on Giffen Goods
Problem in estimating demand response: identification.

Example: Economists claimed potatoes were a Giffen good. As potato price
increased during Irish potato famine of the 1840s, poor Irish consumed more
potatoes.
Hard evidence of this does not exist. Potato famine itself due to negative
supply shock: supply curve moved up and left; therefore price went up. And
in the aggregate, potatoes were in short supply, so on the aggregate potato
consumption could not have increased.
Jensen and Miller randomly assigned staple discount vouchers to very poor
consumers in China: for rice in Hunan (South) and for wheat in Gansu
(North).
Jensen Miller: Giffen goods
They find, especially for rice in Hunan, that giving the subsidy on rice
(decreasing its price) decreased its consumption, and removing the subsidy
increased consumption.
Consider caloric story: I am poor, must meet a target of 41,500 calories every
20-21 days, and earn 560 rupees.
p1 = 40, p2 = 400 are unit prices of starch (say via rice) and protein
(dals/chicken). My utility max occurs at x1∗ = 10, x2∗ = 0.4 (in kg). Calories
are these weights in grams multiplied by 4: So, 40, 000 + 1, 600 = 41, 600.
Jensen Miller 2008 continued
Now, p1 increases to 50 rupees, other prices and income is constant. Will I

consume less rice? If I consume even the earlier 10 kg, I now spend
50 × 10 = 500 rupees on rice; I buy 60 rupees of protein, i.e. 60/400 = 0.15
kg. Total calories = 40, 000 + 600 = 40, 600.
To meet my minimum calorie target, I need to increase rice consumption -
the way cheaper source of calories!
This example needs that rice has no close cheap substitutes available in my
region - which can happen in rural areas with poor distribution networks.
Hicks Demand - Technical
Instead of maximizing utility subject to a given income, we think of the

minimum expenditure we need to achieve a given level of utility u.
The Hicksian demands
(h1∗ (p1 , p2 , u), h2∗ (p1 , p2 , u)) = argminx1 ,x2 ≥0 p1 x1 + p2 x2 ,
such that
u(x1 , x2 ) ≥ u.
And the minimized expenditure

e(p1 , p2 , u) = minx1 ,x2 ≥0 p1 x1 + p2 x2 s.t. u(x1 , x2 ) ≥ u is called the
expenditure function.
Expenditure Minimization:
We set up the Lagrangian
L(x1 , x2 , η) = p1 x1 + p2 x2 + η(u − u(x)).
Interior solution will satisfy first order condition for minimization
∂ u(h1∗ , h2∗ )
p1 = η ∗
∂ x1
∗ ∗
∗ ∂ u(h1 , h2 )
p2 = η .
∂ x2
For interior solution we have
∂ u (h1∗ ,h2∗ )
∂ x1 p1
∂ u (h1∗ ,h2∗ )
= .
p2
∂ x2
∂ u (h1∗ ,h2∗ )
∂ x1 p1
∂ u (h1∗ ,h2∗ )
= .
p2
∂ x2
Marginal rate of substitution at h∗ is equal to p1 /p2 .
∂ u (h1∗ ,h2∗ )
∂ x1 p1
∂ u (h1∗ ,h2∗ )
= .
p2
∂ x2
Marginal rate of substitution at h∗ is equal to p1 /p2 .
and
u(h1∗ , h2∗ ) = u.
This is the same tangency condition as for utility maximization.
Expenditure Minimization vs Utility Maximization:
x2
h∗
u(x) = u
x1
U Max - Expd Min Upshot
We focus on strictly convex indifference curves and unique interior optima.

The diagrams, and the first-order conditions earlier, show that the same
tangency holds for the problems:(i) max u(x1 , x2 ) s.t. p1 x1 + p2 x2 = m; and
(ii) min p1 x1 + p2 x2 s.t. u(x1 , x2 ) = u
But, given the same (p1 , p2 ), when are the optima (x1∗ , x2∗ ) of (i) and (h1∗ , h2∗ )
of (ii) equal?
Clearly, this happens when the budget line and utility level for the 2 problems
are the same: i.e. when m = e(p1 , p2 , u) and v (p1 , p2 , m) = u.
Marshallian Demand and Hicksian Demand:
x2 x2
x∗ h∗
u(x) = v (p, m)
m = e(p, u)
x1 x1
Marshallian and Hicksian Demand
So, if in utility maximization the income is m, then for Marshallian and

Hicksian demands to be equal, the u in expenditure minimization needs to be
v (p1 , p2 , m).
Similarly, if the target utility in the expenditure minimization problem is u,
then the income in utility maximization is required to be e(p1 , p2 , u).
Marshallian Demand and Hicksian Demand:
Duality therefore gives us
xi∗ (p, m) = hi∗ (p, v (p, m))
and
xi∗ (p, e(p, u)) = hi∗ (p, u).
Own Price Effect:
We have
hi∗ (p, u) = xi∗ (p, e(p, u)).
Own Price Effect:
We have
hi∗ (p, u) = xi∗ (p, e(p, u)).
Let’s differentiate this with respect to pi
∂ hi∗ ∂ x ∗ ∂ x ∗ ∂ e(p, u)
= i + i .
∂ pi ∂ pi ∂ m ∂ pi
Own Price Effect:
Note that
∂ e(p, u)
= hi∗ (p, u).
∂ pi
For, e(p1 , p2 , u) = p1 h1∗ + p2 h2∗ + η(u − u(h1∗ , h2∗ )), as the constraint adds 0.
∂ e (p,u ) ∗ ∂ h1∗ ∂ h2∗ ∗ ∗ ∂ h1
∗ ∗
∗ ∗ ∂ h2
∂ p1 = h1 + p1 ∂ p1 + p2 ∂ p1 − ηu1 (h1 , h2 ) ∂ p1 − ηu2 (h1 , h2 ) ∂ p1
∂ h∗ ∂ h∗
= h1∗ + ∂ p11 (p1 − ηu1 (h1∗ , h2∗ )) + ∂ p21 (p2 − ηu2 (h1∗ , h2∗ ))
= h∗1
This is an envelope result: For a small change in p1 , the minimal expenditure

changes only by the corresponding good 1 amount that was being demanded:
h1∗ ; the change in h1∗ , h2∗ get cancelled out by the first-order conditions.
Own Price Effect
This implies
∂ hi∗ ∂ x∗ ∂ x∗
= i + i hi∗ (p, u).
∂ pi ∂ pi ∂m
Own Price Effect:
Since hi∗ (p, u) = xi∗ (p, e(p, u)), we have
∂ hi∗ ∂ x∗ ∂ x∗
= i + i xi∗ .
∂ pi ∂ pi ∂m
Own Price Effect:
Since hi∗ (p, u) = xi∗ (p, e(p, u)), we have
∂ hi∗ ∂ x∗ ∂ x∗
= i + i xi∗ .
∂ pi ∂ pi ∂m
Which can be written as
∂ xi∗ ∂ hi∗ ∂ xi∗ ∗

= − xi .
∂ pi ∂p |∂ m
|{z}i {z }
substitution effect income effect
This says for example: a small decrease in pi swivels Hicksian demand along
the old indifference curve at old utility level, say u. In addition this decrease
∂ xi∗
increases income by xi∗ , and per unit of that, demand changes by ∂m
Own Price income and substitution effects
To summarize, suppose p1 decreases by a tiny amount, to p10 . The

substitution effect on good 1 is the change in its demand along the same
indifference curve: ∂ h1∗ /∂ p1 .
The income effect, by the Chain Rule, is the change in income, times the
change in demand for good 1 in response to change in income: this latter
term equals ∂ x1∗ /∂ m.
Why is the change in income x1∗ ? Think of it as resulting from a price
decrease of a small unit Rupee 1. Then, on the x1∗ units purchased, I save 1
rupee for each of those, totalling up to an income of x1∗ .
Cross Price Effect:
the effect of other good price change on Marshallian demand.
Cross Price Effect:
We have
hi∗ (p, u) = xi∗ (p, e(p, u)).
Cross Price Effect:
We have
hi∗ (p, u) = xi∗ (p, e(p, u)).
Lets differentiate this with respect to pj
∂ hi∗ ∂ x ∗ ∂ x ∗ ∂ e(p, u)
= i + i .
∂ pj ∂ pj ∂ m ∂ pj
Cross Price Effect:
We have already shown that
∂ e(p, u)
= hj∗ (p, u).
∂ pj
Cross Price Effect:
We have already shown that
∂ e(p, u)
= hj∗ (p, u).
∂ pj
This implies
∂ hi∗ ∂ x∗ ∂ x∗
= i + i hj∗ (p, u).
∂ pj ∂ pj ∂m
Cross Price Effect:
Since hj∗ (p, u) = xj∗ (p, e(p, u)), we have
∂ hi∗ ∂ x∗ ∂ x∗
= i + i xj∗ .
∂ pj ∂ pj ∂m
Cross Price Effect:
Since hj∗ (p, u) = xj∗ (p, e(p, u)), we have
∂ hi∗ ∂ x∗ ∂ x∗
= i + i xj∗ .
∂ pj ∂ pj ∂m
Which can be written as
∂ xi∗ ∂ hi∗ ∂ xi∗ ∗

= − xj .
∂ pj ∂ pj |∂ m
{z }
|{z}
Own vs Cross Price Change:
Own price change (hi∗ (p, u) = xi∗ (p, e(p, u)))
∂ xi∗ ∂ hi∗ ∂ xi∗ ∗ ∂ h∗ ∂ x ∗

= − xi = i − i hi∗ .
∂ pi ∂p |∂ m ∂ pi ∂m
|{z}i {z }
Cross price change (hj∗ (p, u) = xj∗ (p, e(p, u)))
∂ xi∗ ∂ hi∗ ∂ xi∗ ∗ ∂ h∗ ∂ x ∗

= − xj = i − i hj∗ .
∂ pj ∂ pj |∂ m
{z } ∂ pj ∂m
|{z}
Response to other price change
Suppose there are 2 goods that for our consumer are both normal goods as
well as substitutes: e.g. chicken and fish.
Suppose the p1 , the price of chicken, decreases. We might expect that the
consumer will increase chicken consumption and reduce fish consumption.
But there is also an income effect: the consumer now has more real income.
Since fish is a normal good, the income effect on fish will be positive.
So, even though ∂ h∗ 2/∂ p1 > 0 tends to reduce fish demand, the overall
effect ∂ x2∗ /∂ p1 may be negative: overall, fish demand may increase if the
income effect dominates the substitution effect.
Cobb-Douglas Utility:
The Marshallian demand is given by
αm βm
x1∗ = , x2∗ = .
(α + β )p1 (α + β )p2
The Hicksian demand is given by
1 β 1 α
∗ u α+β αp2 α+β ∗ u α+β β p1 α+β
h1 (p, u) = , h2 (p, u) = .
A β p1 A αp2
Assume A = 1, α + β = 1
Cobb-Douglas Utility: A = 1, α + β = 1
The Marshallian demand is given by
αm (1 − α)m
x1∗ = , x2∗ = .
p1 p2
The Hicksian demand is given by

(1−α ) α
∗ p2 ∗ p1
h1 (p, u) = uαB , h2 (p, u) = u(1 − α)B .
p1 p2
Cobb-Douglas Utility: A = 1, α + β = 1
Substitution effect
∂ h1∗ ∂ h2∗
= −uα(1 − α)Bp21−α p1α−2 , = uα(1 − α)Bp2−α p1α−1 .
∂ p1 ∂ p1
Income effect
∂ x1∗ ∂ x2∗
x1∗ = uα 2 Bp21−α p1α−2 , x1∗ = uα(1 − α)Bp2−α p1α−1 .
∂m ∂m
Own and Cross Price Effect.
Effect of p1 on x1∗
∂ x1∗ ∂ h∗ ∂ x ∗
= 1 − 1 x1∗ = −uαBp21−α p1α−2 .
∂ p1 ∂ p1 ∂ m
Effect of p1 on x2∗
∂ x2∗ ∂ h∗ ∂ x ∗
= 2 − 1 x2∗ = 0.
∂ p1 ∂ p1 ∂ m
Price Elasticity of Demand:
In 1993 Phillip Morris announced a 18% price cut.
Sales increased by 12.5%.
Philip Morris’s stock fell 26% ($13.4 billion).
Stocks of Nabisco, P & G, Coca-Cola also felt the heat.
Market Demand
Consumer i demand function for commodity 1 is
x1∗i (p, mi ).
When all consumers are price takers, the market demand function for
commodity 1 is
n
x1∗ (p, m1 , . . . , mn ) = ∑ x1∗i (p, mi ).
i =1
Identical consumers
x1∗ (p, mn) = nx1∗i (p, m).
Elasticity
Elasticity measures the “sensitivity” of one variable with respect to another.
The elasticity of variable x with respect to variable y is
%4x
εx,y = .
%4y
Elasticity in Economics:
Quantity demanded of commodity i with respect to the price of i
own-price elasticity of demand.
Quantity demanded of commodity i with respect to the price of j
cross-price elasticity of demand.
Quantity demanded for commodity i with respect to income
income elasticity of demand.
Own-Price Elasticity of Demand: Point Elasticity.
Own price elasticity is defined as
4x1∗
%4x1∗ x1∗
εx1∗ ,p1 = = 4p1
.
%4p1
p1
Why not just use the slope of a demand curve to measure the sensitivity of
demand to a change in own price?
Because the value of sensitivity then depends upon the units of measurement
used for quantity demanded.
Elasticity:
Own price elasticity demand is symbolized by ε
1 ε < −1 , demand is elastic
2 ε > −1, demand is inelastic
3 ε = −1, demand is unitary elastic
4 ε = 0, demand is completely inelastic
5 ε = −∞, demand is infinitely elastic
Example:
Consider the linear demand
a − p1 p1
x1 = , ε =− .
b a − p1
p1
ε = −∞
∞ < ε < −1
a
2 ε = −1
−1 < ε < 0
x1
a ε =0
2b
Cross-Price Elasticity of Demand:
Cross price elasticity is defined as
4x1∗
%4x1∗ x1∗
εx1∗ ,p2 = = 4p2
.
%4p2
p2
Income Elasticity of Demand:
Income elasticity is defined as
4x1∗
%4x1∗ x1∗
εx1∗ ,m = = 4m
.
%4m
m

Lecture 7-8 Substitution-Income Effect-Elasticity-Short

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Lecture 7.

Substitution and Income Effects; elasticity

August 27, 2023

In the consumer model, this translates to how a price change affects

Response of x1 to change in p1 modelled as: what is the sign of

Is ∂ x1∗ (p1 , p2 , m)/∂ p1 < 0 so obvious?

Is ∂ x1∗ (p1 , p2 , m)/∂ p1 < 0 so obvious?

Is ∂ x1∗ (p1 , p2 , m)/∂ p1 < 0 so obvious?

Is ∂ x1∗ (p1 , p2 , m)/∂ p1 < 0 so obvious?

The picture was for Hicks compensation, which we focus on.

Mathematically, write x2 = f (x1 ) for the indifference curve: so its slope

Note we say negative because the Hicksian demand increases as p1 decreases.

Substitution effect is always negative.

Substitution effect is always negative.

While income effect can be positive or negative.

Substitution effect is always negative.

While income effect can be positive or negative.

For normal good

Substitution effect is always negative.

While income effect can be positive or negative.

For normal good

For inferior goods

If Marshallian demand for a good decreases as income increases, we call this

Problem in estimating demand response: identification.

Now, p1 increases to 50 rupees, other prices and income is constant. Will I

Instead of maximizing utility subject to a given income, we think of the

(h1∗ (p1 , p2 , u), h2∗ (p1 , p2 , u)) = argminx1 ,x2 ≥0 p1 x1 + p2 x2 ,

And the minimized expenditure

We set up the Lagrangian

L(x1 , x2 , η) = p1 x1 + p2 x2 + η(u − u(x)).

Interior solution will satisfy first order condition for minimization

For interior solution we have

For interior solution we have

Marginal rate of substitution at h∗ is equal to p1 /p2 .

For interior solution we have

Marginal rate of substitution at h∗ is equal to p1 /p2 .

This is the same tangency condition as for utility maximization.

We focus on strictly convex indifference curves and unique interior optima.

So, if in utility maximization the income is m, then for Marshallian and

Duality therefore gives us

xi∗ (p, m) = hi∗ (p, v (p, m))

xi∗ (p, e(p, u)) = hi∗ (p, u).

Let’s differentiate this with respect to pi

This is an envelope result: For a small change in p1 , the minimal expenditure

Since hi∗ (p, u) = xi∗ (p, e(p, u)), we have

Since hi∗ (p, u) = xi∗ (p, e(p, u)), we have

Which can be written as

∂ xi∗ ∂ hi∗ ∂ xi∗ ∗

To summarize, suppose p1 decreases by a tiny amount, to p10 . The

the effect of other good price change on Marshallian demand.

Lets differentiate this with respect to pj

We have already shown that

We have already shown that

Since hj∗ (p, u) = xj∗ (p, e(p, u)), we have

Since hj∗ (p, u) = xj∗ (p, e(p, u)), we have

Which can be written as

∂ xi∗ ∂ hi∗ ∂ xi∗ ∗

Own price change (hi∗ (p, u) = xi∗ (p, e(p, u)))

∂ xi∗ ∂ hi∗ ∂ xi∗ ∗ ∂ h∗ ∂ x ∗

Cross price change (hj∗ (p, u) = xj∗ (p, e(p, u)))

∂ xi∗ ∂ hi∗ ∂ xi∗ ∗ ∂ h∗ ∂ x ∗

The Marshallian demand is given by