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05b Substitution Income Effects.doc

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Principles of Microeconomics: Substitution and Income Effects SUBSTITITUTION AND INCOME EFFECTS A change in the price of a commodity causes a change in quantity demanded in two ways. The change in the price of a commodity causes a change in the price of the commodity relative to the prices of other goods but the change in the price of X also usually causes a change in real income. Economists separate the quantity response to a change in price into a Substitution effect (the effect of the relative change in price due to a price change with no income effect) from the Income effect (the effect of the change in absolute income due to the price change with no change in relative prices). Determination of these two effects is particularly important in the analysis of consumer surplus. The money measurement of consumer surplus to determine the change in net value for consumers due to a change in price is compromised by the fact that the value of a unit of money ($) differs for individuals and between individuals according to the amount of income held by the individuals. Construction of a ‘Compensated’ Demand function without this income effect is therefore an important consideration in economics. One way of doing this (the Hicks approach) is to define no change in income as no change in utility, i.e., movement along an indifference curve. Substitution and Income Effects of a Price Decrease We illustrate the identification of these two effects and the derivation of the compensated demand function by examining the impact of a decrease in price on the quantity chosen by an individual. Begin with the usual derivation of two points (X , 0 aXo X , P 1 ofX1 Demand function (D) from a decrease in the Price of X (P
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