Dr
Dr. Westerhold
Econ 330
Handout on Substitution and Income Effects
Total effect: the resulting total change in the quantity demanded of x1 when the price of x1 changes (comparing two equilibrium positions—one before and one after the price change). The total effect can be decomposed into two separate effects: The substitution effect and the income effect.
Substitution effect: is an incentive to increase consumption of a good whose price falls, at the expense of the other, now relatively more expensive good.
Income effect: a change in consumer’s real purchasing power brought about by a change in the price of a good. Ultimately, the consumer’s change in the quantity of the good depends on if the good is normal or inferior.
(1) The substitution effect will always result in the person consuming more of the good for which the price has decreased. It will always result in the person consuming less of the good for which the price has increased.
• It does not matter if it is a normal or inferior good.
• If Px (, then the substitution effect will be positive (I buy more x)
• If Px (, then the substitution effect will be negative (I buy less x)
(2) The income effect will differ depending on if the good is normal or inferior.
• If the price of a good decreases, it is as if you have more income (a higher level of purchasing power).
• If the price of a good increases, it is as if you have less income (a lower level of purchasing power)
• Normal good: higher income ((Px) results in higher consumption of x. Income effect is positive.
• Normal good: lower income ((Px) results in lower consumption of x. Income effect is negative.
• Inferior good, higher income ((Px) results in lower consumption of x. Income effect is negative.
• Inferior good, lower income ((Px) results in higher consumption of x. Income effect is positive.
Implications:
(1) For a normal good, price decrease ((Px), the income effect reinforces the substitution effect:
• Positive substitution effect (I buy more because the price is lower)
• Positive income effect (I buy more because I have more “income”)
• Total effect is therefore positive.
(2) For a normal good, price increase ((Px), the income effect reinforces the substitution effect:
• Negative substitution effect (I buy less because price is higher)
• Negative income effect (I buy less because I have less “income”)
• Total effect is therefore negative.
(3) For an inferior good, price decrease ((Px), the income effect partially offsets the substitution effect. The substitution effect is still the largest effect to maintain downward sloping demand (when (Px, Qd ().
• Positive substitution effect (I buy more because the price is lower)
• Negative income effect (I buy less because my “income” is higher; inferior good)
• Total effect will still be positive overall (same direction as substitution effect).
Continued on back
(4) For an inferior good, price increase ((Px), the income effect partially offsets the substitution effect. The substitution effect is still the largest effect to maintain downward sloping demand (when (Px, Qd ().
• Negative substitution effect (I buy less because the price is higher)
• Positive income effect (I buy more because my “income” is lower; inferior good)
• Total effect will still be negative overall (same direction as substitution effect)
(5) The total effect for the normal good is always larger than the total effect of the inferior good. In the normal good case, the income and substitution effect move in the same direction and therefore reinforce one another creating a larger effect. The total effect for the inferior good is smaller because the income and substitution effects work in opposite directions and the income effect partially offsets the substitution effect.
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