Slides CH 5 5.3 Effects of A Price Change

Recap: Applying consumer theory – deriving DD (1)
• Using IC & budget line, varying

price  new optimal bundle 
DD curve
• Change in price  change in
Qd (shift along DD curve),
ceteris paribus
• A change in price changes both
the slope and the position of
the budget line.
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Recap: Applying consumer theory – deriving DD (2)
• Changes in income  change in
DD (shift whole DD curve)
• Income elasticity tells us how DD
will respond to changes in
income
• Distinguish between normal
goods (ξ ≥ 0) and inferior goods
(ξ < 0)
• Now: effects of a price change

Effects of a price change
A change in price affects an individual’s Qd in TWO ways. For a
price increase:
• Substitution effect – consumer substitutes other, relatively
cheaper, goods for the good whose price has increased
– SE is the change in the quantity of a good that a consumer
demands when the good’s price rises, holding other prices and
the consumer’s utility constant.
• Income effect – price increase reduces the consumer’s buying
power, which is in effect like reducing her income
– IE is the change in the quantity of a good that a consumer
demands because of a change in income, holding prices
constant.
Fig 5.4 Substitution & income effects with normal goods
• Enzo has a monthly snack
budget of R150; spends it on
S, samoosas
samoosas & magwinya
• Ps = R5, Pm = R2.50
per month
• Then, Pm increases to R5
• Beginning from budget
constraint L1, an increase in the
price of magwinya rotates
budget constraint to L2.
• The total effect of this price
change, a decrease in quantity
of 12 magwinya per term, can
be decomposed into income M, magwinya
and substitution effects.
per month
Sum up what we did on Fig 5.4 (for a price increase):
Substitution effect (SE):
• Imagine a compensated change in Pm: we ↑Y to offset ↑ Pm, so he
stays on I1.
• Draw imaginary budget constraint, L*, parallel to L2 & tangent to I1.
• SE is the move from bundle e1 to e* - purely because of change in
relative prices.
• Always negative for ↑P (unambiguous).
Income effect (IE):

• Effect of ‘feeling poorer’: shift L* to L2.
• IE is the shift from e* to e2 – price increase is like a drop in income.
• Direction depends on income elasticity:
 normal good – negative IE for ↑P;
 inferior good – positive IE for ↑P (offsets SE).
What about a fall in price?
• We apply the same steps in
reverse
S, samoosas
• Suppose Pm starts at R5
per month
(optimal bundle is e1) and then
decreases to R2.50
• Beginning from budget
constraint L1, a fall in the price
of magwinya rotates budget
constraint to L2.
• Substitution effect (magwinya is
better value now): e1 to e*
• Income effect (Enzo ‘feels
richer’ as he can afford more): Subst effect
e* to e2. Income effect
M, magwinya
Total effect per month
Sum up SE and IE again:
Substitution effect (SE):
• Imaginary budget constraint, L*, tangent to original indiff curve, at new price ratio
(slope)…
• SE is the move along the same indiff curve, from original bundle to new point of
tangency with the imaginary budget line (e1 to e*).
• SE always in opposite direction to price change, as consumer substitutes away from
relatively more expensive good: ↑P ↓Qd, ↓P ↑Qd (unambiguous).
Income effect (IE):

• Effect of price change on purchasing power: shift L* to final position, L2.
• IE is the shift from e* to e2.
• Direction depends on income elasticity:
 normal good – same direction as SE i.e. ↑P ↓Qd, ↓P ↑Qd
 inferior good – offsets SE i.e. ↑P ↑Qd, ↓P ↓ Qd
(usually, SE > IE, so total effect is still same direction as SE.)

Substitution & income effects with ordinary inferior goods
(NOT Giffen goods) • Siya spends her budget on
samoosas and plain cookies.
S, Samoosas
• For Siya, cookies are an
inferior good – they’re cheap
/ month
and filling when cash is short.
• When the price of cookies rises,
SE will ↓Qd as expected…
• But IE will ↑Qd (she feels poorer
and cookies are an inferior
good).
Substitution effect C, plain cookies /

Income effect month
Total effect
Income and substitution effects with an inferior good
• If a good is inferior, the income effect and the substitution effect
move in opposite directions.
• For most inferior goods, the income effect is smaller than the
substitution effect…
• …so the total effect is still in line with the Law of Demand (↑P
↓Qd, and vice versa)
• If the income effect more than offsets the substitution effect, we
have a Giffen good, for which a decrease in its price causes the
quantity demanded to fall.

Giffen goods
• An inferior good, with not many substitutes available, that is such a
big part of a household’s budget that income effect of a price
change > substitution effect,
• so ↓P causes ↓Qd & vice versa;
• upsloping DD curve! (Law of DD???)
• Examples? Very rare!

• e.g. Irish potatoes (now disputed);
• Chinese ‘experiment’ with subsidised wheat & rice (Harvard study).
• Strongly inferior - & ↓P is like ↑Y.

Solved Problem 5.5: Giffen good example
• Ximing spends his money on rice, a Giffen good, and all
other goods. Show that when the price of rice falls, Ximing
buys less rice. Decompose this total effect of a price change
on his rice consumption into a substitution effect and an
income effect.

Solved Problem 5.5: P↓ for Giffen good
Even though the substitution effect
is positive when P↓….
…the income effect is negative
(since this is an inferior good) and
larger than the substitution effect
(since it is a Giffen good).

Giffen goods cont.
• “Property is the ultimate Giffen good” – what do you think?
P houses
Upward shifts of a
‘normal’ DD curve, not
movement along an
upsloping DD curve.
Q, houses sold

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Recap: Applying consumer theory – deriving DD (1)

• Using IC & budget line, varying

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Income effect (IE):

Income effect (IE):

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Substitution effect C, plain cookies /

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

• Examples? Very rare!

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

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