1. Decomposition of the Total Effect into Substitution and Income Effects
Week 4

2. Income and Substitution Effects
In a demand relationship the quantity consumed changes with price but what does the quantity change actually consist of?
Substitution Effect - substitute other goods for A as Price of A rises
Income Effect - as price of A falls, real income rises and so spend more on all goods
Lecture 6

3. Application to Different Types of Goods
Direction and size of effects varies with type of good
Normal Good - as price falls, consumption rises
- as income rises, consumption rises
Inferior Good - as price falls, consumption rises
- as income rises, consumption falls
Giffen Good - as price falls, consumption falls
- as income rises, consumption falls
Lecture 6

4. Income: 3 to 2 or C to B (-ve) Price effect: A to B or 1 to 2 U1
Other Goods
Normal Good U2
Subs: 1 to 3 or A to C (-ve)
Income: 3 to 2 or C to B (-ve)
Price effect: A to B or 1 to 2 U1 B A C
BC2 1 3 2
BC1
BC3 QA
Decrease in Price

5. Income: 3 to 2 or C to B (+ve) Price effect: A to B or 1 to 2
Other Goods
Inferior Good
Subs: 1 to 3 or A to C (-ve)
Income: 3 to 2 or C to B (+ve)
Price effect: A to B or 1 to 2 B A U2 C U1
BC2 QA 2 3
BC1
BC3 1
Decrease in Price

6. Income: 3 to 2 or C to B (+ve) Price effect: A to B or 1 to 2
Giffen Good
Other Goods
Subs: 1 to 3 or A to C (-ve)
Income: 3 to 2 or C to B (+ve)
Price effect: A to B or 1 to 2 B A U2 C U1
BC2 2 1 3
BC1
BC3 QA
Decrease in Price

7. Income and Substitution Effects
Slutsky equation
Total effect of price change = SE + IE
Slutsky’s theorem states that the substitution effect of a price change (relative to quantity) is negative.
We isolate the substitution effect by taking away from (giving) the consumer enough money to put her at the same level of satisfaction as before the price change.

8. Income and Substitution Effects
Total effect of a price change for:
normal good is negative. Because the negative IE reinforces the already negative SE. For price fall, quantity DD increases.
Inferior good is still negative, but –SE > +IE. Quantity DD increases but less than the case for normal goods
Giffen good is positive because –SE < +IE. Quantity DD falls.

9. Labor-Leisure Choice Leisure - all time spent not working.
The number of hours worked per day, H, equals 24 minus the hours of leisure or nonwork, N, in a day:
H = 24 − N.
The price of leisure is forgone earnings.
The higher your wage, the more an hour of leisure costs you.

10. Labor-Leisure Choice: Example
Jackie spends her total income, Y, on various goods.
The price of these goods is $1 per unit.
Her utility, U, depends on how many goods and how much leisure she consumes:
U = U(Y, N).
Jackie’s earned income equal:
wH.
And her total income, Y, is her earned income plus her unearned income, Y*:
Y = wH + Y*.

11. Figure 5.8 Demand for Leisure
(a) Indifference Curves and Constraints
Time constraint
, Goods per day Y I 1
Budget Line, L1 L 1
Y = w1H
Y = w1(24 − N). – w 1 1 e 1 Y 1 N1
= 16 24 N
, Leisure hours per day 24 H 1
= 8 H,
Work hours per day
(b) Demand Curve w , W
age per hour
Each extra hour of leisure she consumes costs her w1 goods. w 1 E1 N1
= 16
N, Leisure hours per day H 1
= 8
H, Work hours per day

12. Figure 5.8 Demand for Leisure
(a) Indifference Curves and Constraints I 2
Time const r
aint L 2
, Goods per day – w 2 Y 1 I 1 e 2 Y 2
Budget Line, L1 L 1
Y = w1H
Y = w1(24 − N). – w 1 1 e 1 Y 1 N 2
= 12 N1
= 16 24 N
, Leisure hours per day 24 H 2
= 12 H 1
= 8 H,
Work hours per day
(b) Demand Curve w , W
age per hour
Budget Line, L2
Y = w2H
Y = w2(24 − N).
w2 > w1 E w 2 2 w 1 E1
Demand for leisure N 2
= 12 N1
= 16
N, Leisure hours per day H 2
= 12 H 1
= 8
H, Work hours per day

13. Figure 5.9 Supply Curve of Labor

14. Income and Substitution Effects of a Wage Changey a I 2
Time const r
aint L 2
, Goods per d
Since income effect is positive, leisure is a normal good. I 1 Y L * e e * 2 L 1 e 1 N * N N 24 N
, Leisure hours per d a y 1 2 24 H * H H H , W o r
k hours per d a y 1 2
Substitution effect
Total effect
Income effect

15. Backward Bending Labor Supply Curve
(a) Labor-Leisure Choice
(b) Supply Cu r v
e of Labor y
Supply curve of labor a L 3 I 3
Time const r
aint E 3
age per hour
, Goods per d W I 2 , Y w E 2 I 1 e 3 L 2 e 2 E 1 L 1 e 1 H 2 H 2 H 3 H 3 24 H H 24 1 1 H , W o r
k hours per d a y H , W o r
k hours per d a y
but at high wages, an increase in the wage causes the worker to work less….
At low wages, an increase in the wage causes the worker to work more….

16. Ordinary curve vrs compensated demand curve
Compensating variation ensures that the consumer remains on the same IC. DDc is steeper than ordinary DDo curve. The slope of the DDc curve is larger for a normal good. The Hicksian demand function.
Ordinary DDo curve considers the effect of IE. The DDo is flatter. The slope of the DDo curve is smaller. The Marshallian demand function.
The Marshallian demand function is the ordinary market demand function we have been discussing all along.

17. Derive the Ordinary and Compensated Demand curves from this diagram
Other Goods
Normal Good U2
Derive the Ordinary and Compensated Demand curves from this diagram U1 B A C
BC2 1 3 2
BC1
BC3 QA
Decrease in Price

18. End