Lecture 2: Market Demand and

Income/Substitution Effects

Alfonso Irarrazabal
September, 2023

1
Introduction
Overview

◦ Demand Function
⋄ Normal and Inferior Goods
⋄ Income Offer Curves and Engel Curves
⋄ The Price Offer Curve and the Demand Curve
⋄ Substitute, Complements, and Inverse Demand Function
◦ The Slusky Equation
⋄ Substitution Effect
⋄ Income Effect

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The Demand Functions
Demand Functions

◦ The consumer’s demand functions give the optimal amounts

of each goods as a function of the prices and income.
◦ We write the demand functions as follows

x1 = x1 (p1 , p2 , m)
x2 = x2 (p1 , p2 , m)

◦ The left hand side represents the quantity demanded, whereas

the right hand side is a function with three arguments.
◦ In today’s lecture we will consider how demand changes when
prices and income change.

3
∆m : Normal and Inferior Goods

◦ For a normal good the demand increases when the income

increases, ie: dx
dm > 0.
1

4
∆m : Inferior Goods

◦ For an inferior good the demand decreases when the income

increases.

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Income Offer Curves
∆m : Income Offer Curves

◦ We can construct the income offer curve (or income expansion

path) by collecting the demanded bundles when we change
income.
◦ The income expansion path will be positive sloped if the good
is normal.

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Examples: Perfect Substitutes

◦ When goods are perfect substitutes (p1 < p2 ), the consumer

only consumes good 1.

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Examples: Perfect Complements

◦ When goods are perfect complements the consumer buy

goods in fixed proportion independent of the prices.

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Examples: Cobb Douglas

◦ If the utility is u(x1 , x2 ) = x1a x21−a , then the demand for x1 is

x1 = am/p1 .
◦ Both Engel and Income Offer Curves are linear.

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Examples: Homothetic Preferences

◦ Homothetic preferences implies that if income is tm, then

demand for both goods become tx1 and tx2 .
◦ If consumer has homothetic preferences, then the Engle curve
is linear.
◦ Perfect complements, perfect substitutes and Cobb Douglas
are all homothetic preferences.

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Examples: Quasilinear Preferences

◦ Quasilinear preferences have special Engel curves.

◦ A Quasi-linear preference can be represented by

u(x1 , x2 ) = v (x1 ) + x2

where v (x1 ) is any function.

◦ The optimality condition (U-max) is given by solving

v ′ (x1∗ ) p1
=
1 p2
Hence, the demand for x1 is independent of income.
◦ And x2∗ = (1/p2 )(m − p1 x1∗ )

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Examples: Quasilinear Preferences

◦ Quasilinear utility features zero income effect.

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Price Offer Curves
∆p1 : Ordinary Goods

◦ Suppose we decrease p1 (keeping constant p2 and m). How

does the demand for good 1, x1 , change?
◦ For ordinary goods, when p1 falls the demand x1 increases.

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∆p1 : Giffen Goods

◦ For Giffen goods, a decrease in the price leads to an decrease

in the quantity demanded.

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∆p1 : The Price Offer Curve and the Demand Function

◦ The price offer curve results when connecting all the optimal
bundles for different price levels.
◦ The demand function shows the optimal choice of x1 for
different levels of p1 .

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Offer and Demand Curves : Perfect Substitutes

◦ We fix p2 and track how demand changes when we

decrease/increase the price.

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Offer and Demand Curves : Perfect Complements

m
◦ Recall the demand function : x1 = p1 +p2

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Substitutes and Complements

◦ If the demand of good 1 goes up when the price of good 2

goes up then we say that good 1 is a substitute for good 2.
◦ Mathematically,
∂x1
>0
∂p2
◦ Similarly, if the demand of good 1 goes down when the price
of good 2 goes up then we say that good 1 is a complement
for good 2.
◦ Mathematically,
∂x1
<0
∂p2

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∆p1 : The Inverse Demand Function

◦ The inverse demand function is the demand function viewing

price as a function of quantity.

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The Slutsky Equation: Substitution
and Income Effects
Substitution and Income Effects

◦ We now study in detail how demand changes when we change

the price of a good.
◦ When the price of a good changes, there are two effects: 1)
the rate at which you exchange one good for another changes
and 2) the total purchasing power of your income also
changes.
◦ Substitution effect: refers to the change in the rate of
exchange between the two goods.
◦ Income effect : refers to the change in demand due to
having more purchasing power.

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Slutsky Equation: Substitution Effect

◦ If we let the price of good one (p1 ) fall, it means that you
have to give up less of good 2 to buy good 1.
◦ At the same time, if p1 goes down, it means that your money
income will allow you to buy more of good 1.

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Slutsky Equation: Substitution Effect

◦ When the price of good 1 falls, we consider the case of a

hypothetical income so the consumer can afford the original
bundle.
◦ First, a budget line with the new slope that keeps the old
bundle just affordable (pivoted line) and 2) a shift in income.

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Slutsky Equation: Substitution Effect

◦ Suppose the consumption bundle (x1 , x2 ) lies on the pivoted

budget line, and that the bundle is just affordable with income
m.
◦ Now suppose the price of good 1 goes up and calculate how
much income is needed, m′ , so the original bundle is just
affordable.
◦ Then, we have

m′ = p1′ x1 + p2 x2
m = p 1 x1 + p 2 x2

◦ Subtracting terms we have

m′ − m = x1 [p1′ − p1 ]

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Slutsky Equation: Substitution Effect

◦ Equivalently,
∆m = x1 ∆p1

◦ Suppose originally the current consumption of candy is

x1 = 20 and the price goes up from p1 = 4 (nok/piece) to
p1′ = 6.
◦ Then, we have that income will have to increase by

∆m = x1 ∆p1 = 20 × 2 = 40

to make the old consumption (x1 = 20) affordable.

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Slutsky Equation: Substitution Effect

◦ The optimal choice for the pivotal budget is Y .

◦ The difference between Y and X measures the change in
consumption when prices changed but the purchasing power
remains constant.

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Slutsky Equation: Substitution Effect

◦ Formally, the substitution effect ∆x1s is the change in demand

for good 1 when prices change from p1 to p1′ and income
increases to m′ to keep the same purchasing power

∆x1s = x1 (p1′ , m′ ) − x1 (p1 , m)

◦ We need to evaluate the demand at two points : (p1′ , m′ ) and

(p1 , m).
◦ The change can be small or large depending on the shape of
the indifference curve.

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Slutsky Equation: Income Effect

◦ The second stage of the price adjustment occurs when income

shifts keeping relative prices constant.
◦ We now change income from m to m′ keeping prices (p1′ , p2 )
constant.

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Slutsky Equation: Income Effect

◦ Formally, the income effect ∆x1n is the change in demand for

good 1 when prices change from m to m′ holding the price of
good 1 at p1′

∆x1n = x1 (p1′ , m) − x1 (p1′ , m′ )

◦ The income effect could be positive or negative depending on

whether the good is normal (positive) or inferior (negative).

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Slutsky Equation: The Total Change in Demand

◦ The total change in demand ∆x1 is the change in demand due

to the change in price, holding income constant,

∆x1 = x1 (p1′ , m) − x1 (p1 , m)

◦ We can break down the total change into two components:

the substitution and income effect.

∆x1 = ∆x1s + ∆x1n

or

x1 (p1′ , m) − x1 (p1 , m) = [x1 (p1′ , m′ ) − x1 (p1 , m)]

+ [x1 (p1′ , m) − x1 (p1′ , m′ )]

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Slutsky Equation: Rate of Change

◦ Let us define the negative effect, ∆x1m

∆x1m = x1 (p1′ , m′ ) − x1 (p1′ , m) = −∆x1n

◦ The Slutsky identity is then given by

∆x1 = ∆x1s − ∆x1m

◦ If we divide by ∆p1
∆x1 ∆x1s ∆x1m
= −
∆p1 ∆p1 ∆p1
◦ The first term is term is the substitution effect, whereas the
second term is the income effect.

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Slutsky Equation: Rate of Change

◦ Recall
∆m = x1 ∆p1
or
∆m
∆p1 =
x1
◦ Substitute into the Slutsky equation
∆x1 ∆x1s ∆x1m
= − x1
∆p1 ∆p1 ∆m
This is the Slutsky equation in rate of change.
◦ Written in terms of derivative
∂x1 (p1 , p2 , m̄) ∂x s (p1 , p2 , x¯1 , x¯2 ) ∂x1n (p1 , p2 , m̄)
= 1 + x1
∂p1 ∂p1 ∂m

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Examples: Perfect Complements

◦ First, notice that substitution effect is zero.

◦ The entire change is due to income effects.

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Examples: Perfect Substitutes

◦ When goods are perfect substitutes, the entire effect is due to

substitution.

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Examples: Quasilinear Preferences

◦ A change in income does not affect good 1, so all the change

in demand is due to substitution effects.

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Another Substitution Effect

◦ Suppose that now, instead of pivoting around the original

bundle, we roll the budget line around the indifference curve.

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An Example
An Example: Computing Substitution and Income Effects

◦ Suppose a consumer has the following demand function

m
x1 = 10 +
10p1
His income is 1200 per week, and the price of milk is 30 per
liter.
◦ His demand for milk is
1200
x1 = 10 + = 10 + 4 = 14
10 × 30
liters per week.
◦ Now suppose the price of milk falls to $20 per liter. Then, the
demand increases to x1 = 10 + (1200/(10 × 20)) = 16 liters
per week.

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An Example : Substitution Effect

◦ Compute the the level of income to make the old bundle

affordable

∆m′ = x1 ∆p1′ = 14 × (−10) = −140

◦ Thus, the new income is m′ = m + ∆m = 1200 − 140 = 1060.

◦ We can compute
1060
x1 (p1′ , m′ ) = 10 + = 15.3
10 × 20
◦ Hence, the substitution effect is

∆x1s = x1 (p1′ , m′ ) − x1 (p1 , m) = 15.3 − 14 = 1.3

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An Example : Income Effect

◦ The income effect is

∆x1n = x1 (p1′ , m) − x1 (p1′ , m′ )

◦ We need to calculate
1200
x1 (p1′ , m) = 10 + = 16
10 × 20
◦ Hence, the income effect is

∆x1n = 16 − 15.3 = 0.7

◦ The total demand effect is

∆x1 = 1.3 + 0.7 = 2.

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