7 3 Income And Substitution Effects
Income and substitution effects
The inverse relationship between price and quantity demanded results from both an income effect and a substitution effect. A change in price causes a change in both the relative price of the product and the purchasing power of the consumer’s income. Either one of these changes taken in isolation would bring about a change in the quantity demanded. One can think of the total change in quantity demanded brought about by a change in price as being the sum of these two isolated changes. In algebraic terms, we
∆Qd
∆Qd
∆Qd can write:
=
substitution effect +
income effect. Our strategy will be to find the income
∆P
∆P
∆P effect; the substitution effect is then found as the difference between the total effect (the left-hand side of the equation) and the income effect.
∆Qd ∆I
∆Qd
Consider, then, the income effect term. It can be rewritten as
.
income effect =
∆I ∆P
∆P
That is, the income effect is the product of two terms. The first term measures the amount by which a change in income changes quantity demanded; the second term measures the amount by which a change in the price changes a consumer’s income, or purchasing power. Multiplying them gives us the income
∆I
dollars; each one of these dollars effect: a price increase reduces the consumer’s purchasing power by
∆P
∆Qd reduces the quantity demanded by units. ∆I
For example, consider an individual who is currently purchasing four DVDs per month. How might we measure the income effect of a $1 increase in the price of DVDs? Each of these four discs now costs $1 more so, all else equal, our consumer will be spending $4 more each month on DVDs. This reduces her purchasing power by $4. In general, each dollar increase in the price will reduce purchasing
∆I
= – Qd. Substituting this into our formula, we power by an amount equal to the quantity demanded:
∆P
∆Qd
∆Qd
∆Qd
=
. can write1:
substitution effect – Qd
∆I
∆P
∆P
Having found the income effect,
The inverse relationship between price and quantity demanded results from both an income effect and a substitution effect. A change in price causes a change in both the relative price of the product and the purchasing power of the consumer’s income. Either one of these changes taken in isolation would bring about a change in the quantity demanded. One can think of the total change in quantity demanded brought about by a change in price as being the sum of these two isolated changes. In algebraic terms, we
∆Qd
∆Qd
∆Qd can write:
=
substitution effect +
income effect. Our strategy will be to find the income
∆P
∆P
∆P effect; the substitution effect is then found as the difference between the total effect (the left-hand side of the equation) and the income effect.
∆Qd ∆I
∆Qd
Consider, then, the income effect term. It can be rewritten as
.
income effect =
∆I ∆P
∆P
That is, the income effect is the product of two terms. The first term measures the amount by which a change in income changes quantity demanded; the second term measures the amount by which a change in the price changes a consumer’s income, or purchasing power. Multiplying them gives us the income
∆I
dollars; each one of these dollars effect: a price increase reduces the consumer’s purchasing power by
∆P
∆Qd reduces the quantity demanded by units. ∆I
For example, consider an individual who is currently purchasing four DVDs per month. How might we measure the income effect of a $1 increase in the price of DVDs? Each of these four discs now costs $1 more so, all else equal, our consumer will be spending $4 more each month on DVDs. This reduces her purchasing power by $4. In general, each dollar increase in the price will reduce purchasing
∆I
= – Qd. Substituting this into our formula, we power by an amount equal to the quantity demanded:
∆P
∆Qd
∆Qd
∆Qd
=
. can write1:
substitution effect – Qd
∆I
∆P
∆P
Having found the income effect,