Income and Substitution Effects: Analyzing Price Change

Income and Substitution Effects: Analyzing Price Change
When the price of a good changes, the consumer adjusts their choices. But why exactly does this happen? Decomposition into the income effect and substitution effect helps to understand the response mechanism and to explain the law of demand.

Two Effects of Price Change

When the price of good X decreases, two changes occur:

1. Change in relative prices: X becomes cheaper relative to Y. A rational consumer should substitute some of Y for X.
2. Change in real purchasing power: with the same nominal income, you can buy more. It is as if your income has increased.

These two effects may act in the same direction or in different directions.

Substitution Effect

Substitution Effect — a change in consumption caused by a change in relative prices while utility remains constant.

Characteristics:

• Always negative: price decrease → increase in consumption
• Reflects the principle: we buy more of that which has become relatively cheaper
• Operates for any goods — normal and inferior
• Measurement: how much the consumer would change their purchase if the price changed, but we "compensated" the change in income so that utility remained the same.

Income Effect

Income Effect — a change in consumption caused by a change in real purchasing power under new prices.

For normal goods:

• Price decrease = increase in real income → more consumption
• The income effect is positive (in the same direction as the substitution effect)

For inferior goods:

• Price decrease = increase in real income → less consumption of the inferior good
• The income effect is negative (opposite to the substitution effect)

Two Approaches to Decomposition

Hicks Approach: Compensation preserving the same level of utility

• "Imaginary" income at which the consumer reaches the original indifference curve under new prices
• More common in theory

Slutsky Approach: Compensation preserving the possibility to buy the original bundle

• "Imaginary" income = cost of the original bundle at new prices
• Easier to compute

In practice, both approaches produce similar results for small price changes.

Graphical Analysis (Hicks)

Initial position: point A — optimum on budget line 1 and indifference curve U1.
Decrease in price X: budget line pivots — line 2.
New optimum: point C on line 2 and curve U2.

Decomposition: Draw a "compensated" budget line — parallel to the new one (with new price ratio), but tangent to the old indifference curve U1
Tangency point — B
A → B: substitution effect (movement along U1)
B → C: income effect (transition to U2)

Giffen Goods

Giffen good — a hypothetical good for which a decrease in price leads to a decrease in demand.

Conditions for existence:

• The good must be inferior (negative income effect)
• The income effect must exceed the substitution effect in absolute value
• The good must occupy a large proportion of the budget (so that the income effect is significant)

Theoretical example:
A very poor family, most of the budget spent on bread. When the price of bread falls, "freed" income is spent on meat (a normal good). Bread consumption falls.

Empirically: Giffen goods are almost never observed. Some studies found the effect in China (rice, noodles) under extreme poverty, but results are controversial.

Veblen Goods and Prestige Consumption

Veblen goods — goods whose demand increases with price due to the prestige effect.

Important: this is not a violation of the law of demand. This is a shift of the demand curve — high price changes the perception of quality/status of the good.
With fixed perceptions, the law of demand holds.

Examples: luxury brands, works of art, exclusive wines.

Practical Applications

• Tax Policy:
  Decreasing price through a subsidy — substitution effect stimulates consumption
  But the income effect from the subsidy may be spent on other goods
  For targeted increase of consumption — per-unit subsidies are more effective than cash transfers

• Labor Supply:
  Wage increase: substitution effect — more labor (leisure becomes more expensive)
  Income effect — less labor (can afford more leisure)
  At high wages, the income effect may dominate — "backward bending" labor supply curve

• For the Investor:
  Understanding how consumers react to price changes
  Inferior goods — anti-cyclical investments (demand rises in recession)
  Luxury goods — pro-cyclical (demand falls in recession)