1. Lectures in Microeconomics-Charles W. Upton Income and Substitution Effects

2. We know that both price and income influence demand.

3. Income and Substitution Effects We know that both price and income influence demand. A price change means an income change.

4. Income and Substitution Effects We know that both price and income influence demand. A price change means an income change. You are purchasing 10 apples at $1 each. If the price falls to 50¢, you effectively get $5 more income

5. Income and Substitution Effects The Basic Indifference Curve YoYo A I1I1 Utility Maximization Y o /p o

6. Income and Substitution Effects The Basic Indifference Curve YoYo A I1I1 Utility Maximization Y o /p o Your income is Y o ; you could purchase up to Y o /p o apples

7. Income and Substitution Effects The Basic Indifference Curve YoYo A I1I1 Utility Maximization Y o /p o You are on indifference curve I 1

8. Income and Substitution Effects Apple Prices Drop YoYo A I1I1 Y o /p o Y o /p 1

9. Income and Substitution Effects Apple Prices Drop YoYo A I1I1 Y o /p o Y o /p 1 The budget line rotates out and you move to indifference curve I 2 I2I2

10. Income and Substitution Effects Apple Prices Drop YoYo A I1I1 Y o /p o Y o /p 1 The budget line rotates out and you move to indifference curve I 2 I2I2 Two things have occurred: a price cut and an increase in income

11. Income and Substitution Effects Apple Prices Drop YoYo A I1I1 Y o /p o Y o /p 1 The budget line rotates out and you move to indifference curve I 2 I2I2 Two things have occurred: a price cut and an increase in income Lets separate those two effects starting with the substitution effect

12. Income and Substitution Effects The Substitution Effect YoYo A I1I1 Y o /p o Y o /p 1 To isolate the effect of the lower price, imagine a budget line reflecting the lower price but tangent to the old indifference curve I2I2

13. Income and Substitution Effects The Substitution Effect YoYo A I1I1 Y o /p o Y o /p 1 To isolate the effect of the lower price, imagine a budget line reflecting the lower price but tangent to the old indifference curve I2I2 We would move to the red dot

14. Income and Substitution Effects The Substitution Effect YoYo A I1I1 Y o /p o Y o /p 1 To isolate the effect of the lower price, imagine a budget line reflecting the lower price but tangent to the old indifference curve I2I2 We would move to the red dot This is the substitution effect

15. Income and Substitution Effects The Substitution Effect YoYo A I1I1 Y o /p o Y o /p 1 To isolate the effect of the lower price, imagine a budget line reflecting the lower price but tangent to the old indifference curve I2I2 We would move to the red dot This is the substitution effect The substitution effect is always negative - Diminishing MRS guarantees it

16. Income and Substitution Effects The Income Effect YoYo A I1I1 Y o /p o Y o /p 1 I2I2 The substitution effect is only part of the story

17. Income and Substitution Effects The Income Effect YoYo A I1I1 Y o /p o Y o /p 1 I2I2 The substitution effect is only part of the story The other part of the impact of the price change is the movement from the red dot to the green dot

18. Income and Substitution Effects The Income Effect YoYo A I1I1 Y o /p o Y o /p 1 I2I2 The substitution effect is only part of the story The other part of the impact of the price change is the movement from the red dot to the green dot This is the income effect

19. Income and Substitution Effects The Combined Effect YoYo A I1I1 Y o /p o Y o /p 1 I2I2 We effectively break the price change down into its two components: the substitution effect and the income effect.

20. Income and Substitution Effects The Combined Effect YoYo A I1I1 Y o /p o Y o /p 1 I2I2 We effectively break the price change down into its two components: the substitution effect and the income effect. While the substitution effect is always negative, the income effect may or not be positive

21. Income and Substitution Effects

25. End ©2006 Charles W. Upton