L9 Income and Substitution

Aims of the Lecture

• Focus: Income and Substitution Effects in Consumer Theory

• Topics Covered:

  • Previous session overview: finding optimal choices based on preferences, income, and prices.

  • Today's focus: how choices change with variations in income and price.

• Objectives:

  • Derive an individual’s demand curve.

  • Explore the relationship between consumption and income.

  • Analyze how consumption changes due to income and substitution effects.

  • Understand how price changes affect consumer behavior (richer/poorer scenarios, relative price changes).

Lecture Outline

1. Change in Income:

   • Income-consumption curve.

   • Engel curve.

2. Change in Price:

   • Price-consumption curve.

   • Demand curve.

3. Income and Substitution Effects.

Reading

• Review Chapters 4 from the following books:

  • Lipsey and Chrystal (14th ed.), pp. 87-100

  • Lipsey and Chrystal (13th ed.), pp. 83-96

  • Sloman, Wride, and Garratt (11th ed.), pp. 119-129

  • Sloman, Wride, and Garratt (9th ed.), pp. 113-120

Income-consumption Curve

• Definition: Shows how consumption varies with changes in income.

• Effects of Income Change:

  • An increase in income shifts the budget constraint to the right.

Income-consumption Curve: Inferior Goods

• Definition: Inferior goods are those for which demand decreases as consumer income rises.

• Graphical Representation:

  • The income-consumption curve shifts downward for inferior goods.

Engel Curve

• Definition: Illustrates the relationship between income and the quantity demanded of a good.

• Analysis:

  • Utilizes indifference curves to demonstrate how income changes affect demand for goods.

  • The slope of the Engel curve indicates the income elasticity of demand.

Price-consumption Curve

• Definition: Shows how consumption varies with price changes.

• Graphical Analysis:

  • A decrease in the price of good X pivots the consumption possibilities outward.

Demand Curve

• Derivable from the price-consumption curve.

• Price and Consumption: Examines consumption variations as price fluctuates.

Income and Substitution Effects

• Concept:

  • The demand typically declines with increased prices.

  • Income Effect: Consumers feel poorer and may reduce quantity bought.

  • Substitution Effect: Consumers tend to switch to alternative products.

• Indifference Framework:

  1. Analyze how price changes influence consumption by holding relative prices constant.

  2. Examine choices while maintaining utility constant.

Budget Constraint

• Definition: Illustrates affordable consumption bundles based on income.

• Trade-off Analysis:

  • Reveals the sacrifice needed to acquire additional units of a good. Example: trading pizza for beer.

Substitution Effect of Price Change

• Concept: When the price of good X increases, it changes consumer choice.

• Graph Analysis: Identifies changes along the indifference curves reflecting consumption adjustment due to relative price changes.

Income Effect of Price Change

• Impact: Increases in the price of good X implies a need to reassess how much income goes to buying good X.

• Objective: Identifies how much income must be adjusted to return to the original indifference curve.

Inferior Goods

• Behavior upon price change:

  • With price increases, quantity demanded of inferior goods may paradoxically rise due to reduced purchasing power.

Giffen Goods

• Definition: A unique type of inferior good where price increases lead to higher demand due to the dominating income effect.

• Conditions: Requires specific conditions for Giffen behavior to manifest.

Summary of Key Concepts

1. Income-consumption Curve: Shows consumption changes with income - upward for normal goods, downward for inferior goods.

2. Price-consumption Curve: Corresponds to how consumption changes with price - assists in finding the demand curve.

3. Income Effect and Substitution Effect:

   • Income Effect: How price changes affect consumption while holding relative prices constant.

   • Substitution Effect: How price adjustments affect choice while keeping utility constant.

Outcomes Following the Lecture

• Capability to illustrate changes in income/price graphically.

• Ability to derive Engel and demand curves from respective consumption curves.

• Skills to display substitution and income effects visually in consumer theory.