Economics 3030

Intermediate Microeconomic Theory

Topic 2: Consumer Theory (iii)
1. Comparative Statics

 We now consider how the consumer responds to

changes in his market environment

 That is, to changes in:

(i) Endowment income;

(ii) Prices.

 N.B, Comparative Statics / Dynamics

1. Comparative Statics

 Changes in Income

 An increase in endowment income causes a

parallel shift out of the budget constraint

 A decrease in endowment income causes a

parallel shift in of the budget constraint
 Figure 1: Increase in Income
y

x
0
 Figure 1: Increase in Income
y m’ > m

x
0
 Figure 2: Increase in Income
y M
m’ > m
A

I1 x Normal
B y Normal

E1

E0 C

I0 D
x
0
 Figure 2: Increase in Income
y m’ > m
x Inferior
A y Normal

E1

B I1

E0 C

I0 D
x
0
 Figure 2: Increase in Income
y m’ > m

I1
E0 C

E1 x Normal
y Inferior

D x
0
 Figure 2: Increase in Income
y m’ > m

A x Inferior
y Normal

B
x Normal
y Normal

E0 C

x Normal
y Inferior

I0 D
x
0
1. Comparative Statics

 Changes in Prices

 An increase in price causes a pivot inwards

of the budget constraint

 An decrease price causes a pivot outwards

of the budget constraint.
 Figure 3: Fall in Price
y

x
0
2. Income & Substitution Effects

 Price changes affects the optimal choice bundle in two

distinct ways:

 First, there is a change in relative prices as represented

by a change in the slope of the budget constraint.

 Second, there is a change in purchasing power (i.e. real

income). The same level of money income is now worth
more to the consumer in terms of its ability to purchase
both goods.
 Figure 3: Fall in Price
y

x
0
 Figure 3: Fall in Price
y

x
0
 Figure 4: Effects of Fall in Price
y

Fall in price of good x reduces slope of budget

constraint (ERS) - i.e. fall in the relative price of
good x

Fall in price of good x increases consumer’s real

income - i.e. expansion of the budget set

x
0
 Figure 5: Effects of a Fall in Price
y

E1

E0

x
0
 Figure 5: Effects of a Fall in Price
y

E0

E1
x
0
 Figure 5: Effects of a Fall in Price
y

E1

E0

x
0
 Figure 5: Effects of a Fall in Price
y

A
Good x
is Giffen

B
Good x is
Non-Giffen
E0

C
x
0
2. Income & Substitution Effects

 We decompose total effect of price change into:

(i) Income Effect

(ii) Substitution Effect

 The income effect is the adjustment of demand to the change

in real income.

 The substitution effect is the adjustment of demand to the

change in relative prices.
 Figure 6: Income and Substitution Effects
y (Fall in px)

E0

I0
x
0 A
 Figure 6: Income and Substitution Effects
y (Fall in px)

E0
E1

I1
I0
x
0 A B
2. Income & Substitution Effects

 We decompose the overall change in demand into

income and substitution effects by (hypothetically)
adjusting the consumer’s income to restore him to the
level of ‘real income’ he enjoyed before the price
change

 Given the fall in px and the subsequent increase in real

income, we therefore reduce the consumer’s real
income; mechanically, we drag the new budget line
back until it is just tangent to the original indifference
curve.
2. Income & Substitution Effects

 This procedure is denoted a Hicks Compensating

Variation (in money income)

 Hicks defined ‘Real Income’ as ability to enjoy a

particular level of utility (i.e. indfference curve)

 We ‘compensate’ the consumer for the price change

by (hypothetically) adjusting income after price
change until we derive a tangency with the original
indifference curve
 Figure 6: Income and Substitution Effects
y (Fall in px)

E0
E1

I1
I0
x
0 A B
 Figure 6: Income and Substitution Effects
y (Fall in px)

C
E0
E1
E2
I1
I0
x
0 A C B
 Figure 6: Income and Substitution Effects
y (Fall in px)

C
E0
E1
E2
I1
I0
x
0 A C B
 Figure 6: Income and Substitution Effects
y (Fall in px)

E0-E1: Total Effect (x0-x1)

A
E0-E2: Substitution Effect (x0-x2)
E2-E1: Income Effect (x2-x1)

E0
E1
E2
I1
I0
x
0 x0 x2 A x1 B
3. Inferior & Giffen Goods

 In a two good model, a price change always

induces a substitution effect in the opposite
direction of the change in price

 i.e: a rise (fall) in px induces a substitution away

(towards) good x ceteris paribus

 We usually say that ‘… the own price substitution

effect is always negative.’
3. Inferior & Giffen Goods

 Income effect, however, can be positive (i.e. normal

good) or negative (i.e. inferior good)

 Rise in price of a normal good induces a negative

substitution effect and a negative income effect, both
of which act to reduce the demand for good x

 A rise in the price of an inferior good, however,

induces a negative substitution effect but a positive
income effect, thus overall effect is ambiguous
3. Inferior & Giffen Goods

 If, when the price of an inferior good rises, the

positive income effect dominates the negative
substitution effect, we have the case of a Giffen
Good

 That is, a good for which demand rises (falls)

when price rises (falls)

 Giffen goods are very inferior good

 Figure 7: Income and Substitution Effects
y Good x: Normal / Non-Giffen

A I0

C
E0 E1

I1
E2

x
0 A C B
 Figure 8: Income and Substitution Effects
y Good x: Inferior / Non-Giffen

I1
A
I0

E1
C
E0

E2

x
0 A C B
 Figure 9: Income and Substitution Effects
y Good x: Inferior / Giffen
I1

E1

E0

E2

I0
x
0 A C B
3. Inferior & Giffen Goods

 P is a necessary condition for Q if Q implies P.

 Breathing (P) is a necessary condition for being human (Q),

because being human implies you breath.

 P is a sufficient condition for Q if P implies Q.

 Jumping (P) is a sufficient condition for leaving the ground

(Q), because jumping implies you leave the ground.
3. Inferior & Giffen Goods

 P is a necessary and sufficient condition for Q if P

is necessary for Q and Q is sufficient for P.

 ‘Today is the 25th December’ (P) is a necessary

and sufficient condition for ‘today is Christmas
Day’ (Q).
3. Inferior & Giffen Goods

Inferiority is a necessary but not sufficient condition

for Giffeness

Giffeness implies inferiority

But inferiority does not imply Giffeness

4. Measuring Real Income

 An alternative definition of real income is the ability

to consume not a particular level of utility, but
rather a particular bundle of goods

 i.e. we vary the consumer’s money income

following a change in price to permit him to
consumer his original bundle of goods at the new
relative price ratio

 The is known as a Slutsky Compensating Variation

(SCV) in money income.
 Figure 10: Slutsky Compensating Variation
y (Price Fall)

A
C
I0
B I2
I1
x
0
 Figure 11: Slutsky Compensating Variation
y (Price Rise)

C
A I2

I1
I0
x
0
4. Measuring Real Income

 Both Hicks and Slutsky compensating variations

adjust the consumer’s new level of income (i.e. the
level following the price change) such that he is able
to enjoy either his original level of utility (Hicks) or
his original consumption bundle (Slutsky)

 An alternative approach is to adjust the consumer’s

original level of income in such a way that he is able
to enjoy the level of utility (Hicks) or the
consumption bundle (Slutsky) that he would have
been able to enjoy were he to face the change in
prices
4. Measuring Real Income

 That is, we vary the consumer’s money income at the

original relative price ratio to enable him to enjoy the
level of real income (i.e. utility or consumption bundle)
that he would have been able to enjoy from the price
change

 i.e. we provide the consumer with an Equivalent

Variation in money income

 A variation in money income that will adjust the

consumer’s real income in a manner analogous to the
price change
 Figure 12: Hicks Equivalent Variation
y (Price Fall)

I1
I0
x
0
 Figure 13: Hicks Equivalent Variation
y (Price Rise)

C
A

B
I0 I1
x
0
 Figure 14: Slutsky Equivalent Variation
y (Price Fall)

A
C I2

I1
I0
x
0
 Figure 15: Slutsky Equivalent Variation
y (Price Rise)

C
A
I0
B I2
I1
x
0
4. Measuring Real Income

 To summarise, we have eight cases

 Hicks / Slutsky

 Compensating Variation / Equivalent Variation

 Price Rise / Price Fall

 Figure 16.1: Hicks Compensating Variation
y (Price Fall)

A
C
B
I1
I0
x
0
 Figure 16.2: Hicks Compensating Variation
y (Price Rise)

B
C
A

I1
I0
x
0
 Figure 16.3: Slutsky Compensating Variation
y (Price Fall)

A
C
I0
B I2
I1
x
0
 Figure 16.4: Slutsky Compensating Variation
y (Price Rise)

C
A I2

I1
I0
x
0
 Figure 16.5: Hicks Equivalent Variation
y (Price Fall)

I1
I0
x
0
 Figure 16.6: Hicks Equivalent Variation
y (Price Rise)

C
A

B
I0 I1
x
0
 Figure 16.7: Slutsky Equivalent Variation
y (Price Fall)

A
C I2

I1
I0
x
0
 Figure 16.8: Slutsky Equivalent Variation
y (Price Rise)

C
A
I0
B I2
I1
x
0