Income & Substitution Effects Flashcards
(13 cards)
When the price of a good changes, what two effects does it generate on demand?
Substitution Effect: Change in consumption due to the good becoming relatively more or less expensive.
Income Effect: Change in consumption due to a change in real income or purchasing power.
What is the direction of the substitution effect for a price increase?
Always negative — the consumer buys less of the good that has become relatively more expensive, holding utility constant.
What is the Hicksian definition of the substitution effect?
The substitution effect is calculated by adjusting nominal income to keep the consumer on the same indifference curve (same utility) after the price change.
What is the Slutsky definition of the substitution effect?
justs income to keep the same purchasing power as before the price change (i.e. ability to buy the original bundle).
What does the Hicksian demand curve show?
The change in demand for a good when its price changes and utility is held constant (pure substitution effect).
What’s the difference between Marshallian and Hicksian demand?
Marshallian: Regular demand from utility maximisation with given income and prices.
Hicksian: Demand when utility is fixed and income is adjusted accordingly.
How does the income effect depend on the type of good?
Normal good: Income effect is positive (price ↑ → real income ↓ → demand ↓).
Inferior good: Income effect is negative (price ↑ → real income ↓ → demand ↑).
What is a Giffen good?
A good for which the income effect outweighs the substitution effect in the opposite direction, causing demand to rise when price rises.
How is the total effect of a price change on demand decomposed?
TotalEffect=SubstitutionEffect + IncomeEffect
When is the substitution effect large or small?
Large if close substitutes are available (e.g. petrol vs public transport)
Small if few alternatives (e.g. insulin)
When is the income effect large?
When the good takes up a large proportion of income (e.g. rent, fuel, heating).
What happens to substitution and income effects with perfect complements?
There is no substitution effect — goods must be consumed in fixed proportions. All change is from the income effect.
