Topic 3

Income Effects

Substitution and

Suppose the price of X increases. This creates a substitution effect and an income effect.
Consumption Good Y

BC2

BC1

Consumption Good X
The Substitution Effect is due to a relative price change:
X is more expensive relative to Y after the price change.
The slope of the budget constraint is steeper. (Recall that pX/pY is the slope of the
budget constraint when the budget constraints slope changes, this indicates that
relative prices have changed.)
The opportunity cost of consuming good X has increased.
The Income Effect is due to a real income changes
Real income has gone down because nominal income (I) stayed the same but the
price of X (PX) increased.
Feasible set of consumption bundles is smaller.
The following chart illustrates the substitution, income, and total effects of price
increases and decreases for normal and inferior goods.
Substitution Effect
Income Effect
Total Effect
Price Increase
Normal Good
{-}
{-}
{-}
Inferior Good
{-}
{+}
Either
Price Decrease
Normal Good
{+}
{+}
{+}
Inferior Good
{+}
{-}
Either

Consider a decrease in the price of consumption good X. When the price of X decreases,
the budget constraint pivots outward along the axis measuring the quantity of
consumption good X. The consumer moves from utility maximizing consumption bundle
a to utility maximizing consumption bundle b. This movement is the total effect of the
price decrease. It is what we actually observe.
Consumption Good Y

Ya

Yb

b
c

U2
U1

BC1
Xa

Xc

Xb

BC2
Consumption Good X

To identify the substitution and income effects, draw a new dotted line (shown above)
that is just tangent to the original budget constraint (at point c) but with the same slope as
the new budget constraint (BC2). This dotted line will represent enough income to get
back to the original indifference curve (the original level of utility) but with the slope of
the new budget constraint to reflect the new relative prices. In other words, income is
adjusted to keep utility the same from points A to C at the new relative prices.
The substitution effect is from a to c and it is positive. To see this, recall that the slope of
the budget constraint represents the ratio of relative prices (pX/pY). When the slope of the
budget constraint gets flatter, this indicates that pX/pY decreases and that consumption
good X has gotten relatively less expensive. According to the substitution effect,
consumers will substitute toward the consumption good that has gotten cheaper. Thus,
the substitution effect prompts the individual to consume more of good X, which is the
positive effect from a to c.
We argue that the movement from consumption bundle a to consumption bundle c
contains no income effect because both consumption bundles are on the same
indifference curve. If there had been a change in real income, then the same level of
utility would not have been achieved.
The income effect is from c to b and it is positive. Between c and b, the dotted line
moves in a parallel fashion to the new budget constraint. This represents the increase in

real income or purchasing power experienced when prices decrease. An increase in real
income prompts consumers to purchase more of all normal goods, which is the positive
income effect.
We argue that the movement from c to b contains no substitution effect because the
dotted line and the new budget constraint have the same slope. This indicates that there
has been no relative price change between these two lines only a change in real income.
If there had been a change in relative prices, then the two lines would have had different
slopes.
Note that in this example, consumption good X and consumption good Y are substitutes:
when the price of consumption good X decreases, the individual consumes less of
consumption good Y.
We can also show that in this example, as the price of consumption good X decreases,
total expenditures on consumption good X increase. This is because income equals the
price of consumption good X multiplied by the quantity of X consumed price plus the
price of consumption good Y multiplied by the quantity of Y consumed. That is, I = pXX
+ pYY. In this instance, nominal income and the price of consumption good Y have not
change. Since the individual consumes less of consumption good Y when the price of X
decreases, less is spent on Y. Since nominal income is unchanged, more must have been
spent on consumption good X.
We can also determine that the demand curve for consumption good X is inelastic. When
a price increase results in an increase in total expenditures (or, total revenue from the
firms perspective), demand is inelastic.
Now, show this for an inferior good:
Consumption Good Y

b
Yb
a
Ya

U2
c
U1
BC1
Xa

Xb Xc

BC2
Consumption Good X

Here, the income effect is from c to b and it is negative. This is because individuals
consume less of all inferior goods when real income increases.
Note that in this example, consumption good X and consumption good Y are
complements. When the price of consumption good X decreases, the individual
consumes more of consumption good X and consumption good Y.
We can also show that in this example, as the price of consumption good X decreases,
total expenditures on consumption good X decreases. Again, in this instance, nominal
income and the price of consumption good Y do not change. Since the individual
consumes more of consumption good Y when the price of X decreases, more is spent on
Y. Since nominal income is unchanged, less must have been spent on consumption good
X.
We can also determine that the demand curve for consumption good X is elastic. When a
price increase results in an decrease in total expenditures (or, total revenue from the
firms perspective), demand is elastic.
Chelsea, to her parents dislike, has been smoking cigarettes. Trying to dissuade his
daughter from smoking, father Bill asked Chelsea if she would smoke less if the price of
cigarettes were to increase. To this question Chelsea told her father, yes. In the
meantime, equally distraught mother Hillary asked her daughter if she would smoke less
if her allowance were reduced. To this question, Chelsea answered, no, that would make
me smoke more. That night, Bill (excitedly) told his wife Hillary that he was going to
raise the real price of cigarettes through a federal cigarette tax because Chelsea had told
him that if the price of cigarettes went up, she would smoke less. However, Bills
excitement soon turned to concern when Hillary told her husband of Chelseas stated
response to a cut in allowance. Not only is Chelsea smoking, but now shes lying too!,
Hillary exclaimed.
Is Chelsea lying to her parents?
Chelsea may not be lying to her parents. She is letting her father know that her total
effect for cigarettes of a price increase is negative (characteristic of normal and inferior
goods) and shes letting her mother know that her income effect for cigarettes of a
decrease in allowance is positive: if income goes down shell buy more cigarettes
(characteristic of inferior goods). We can conclude that for Chelsea, cigarettes are an
inferior good. Therefore, if the price of cigarettes goes up, her substitution effect will be
negative (because cigarettes are now relatively more expensive), her income effect will
be positive (because you buy more of all inferior goods when you experience a decrease
in real income) and her uncompensated effect will be negative (we know this because its
what she told her father in the dialogue). We can also conclude that Chelseas
substitution effect dominates her income effect. The effect of a price increase for an
inferior good is graphed below.

C
A
U1
B

U2
B2

B1
Cigarettes

The substitution effect is from point A to C and its negative. The income effect is from
point C to B and its positive. The total effect is what is left over (A to B) and it is
negative.
You are the manager of an ad agency that does work for a local tire company. Your
employees are planning an ad campaign. Smith shows you his layout: tire sale, 25% off
our regular price of $50 per tire. Brown shows you her layout: tire sale, buy three tires at
the regular price of $50 each, get the 4th one FREE. You must decide between the
marketing approaches. Being a former economics major, you construct an indifference
map with tires on the horizontal axis and consumption of other goods C on the vertical
axis, you add the relevant budget lines for both pricing schemes and reasonable
indifference curves. Let the price of other consumption goods C be normalized to be
P(C)= $1.00. Let income be I = $400. Based on your analysis, which approach seems
likely to sell more tires? Explain, using an indifference map below.

C
$400

$250

$200

$50

Tires

Would you rather have $100.00 worth of apples or $100.00 in cash? Probably the
$100.00 in cash, because it allows you to spend the gift any way you choose.
Alternatively, if I gave you $100.00 worth of apples, how much cash would I have to give
you instead to make you equally well off? $50.00? Would you rather have $50.00 in
cash or $100.00 worth of apples? $30.00? Would you rather have $30.00 in cash or
$100.00 worth of apples?
Consider targeted tax cuts versus income tax cuts. To spur youths to get more education,
suppose the federal government begins subsidizing the cost of school -- reducing its cost
to the consumer by having the government pay for a fraction of the price of education.
(Assume that individuals can consume either education or units of composite
consumption item Y. Also, let the price per unit of consumption item Y be $1.00).
Let the price of a unit of education be "P" initially. In the figure below, draw a new
budget constraint representing the price of a unit of education decreasing to P(1-s) where
"s" is the subsidy the federal government pays to reduce the cost of a unit of education.
After drawing the new budget constraint, draw the modeled consumer's new indifference
curve, labeled U2, representing the new equilibrium consumption of units of education
and good "Y".
Finally, indicate graphically what the total cost of the subsidy program is for the federal
government.
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Consumption Good Y

U1

BC1
Units of Education
(Hint: make the changes in the budget constraint stark)
Now suppose that a different plan to help consumers is proposed. Some might
disapprove of the subsidy plan described above because it only rewards individuals for
certain behavior -- as exemplified by the fact that you only get a discount if you buy units
of education. Instead, this plan gives a lump-sum cash transfer (like an income tax cut) to
consumers and lets them decide how to spend the money. In particular, this plan gives
consumers exactly enough cash to get to the new level of utility you drew above, U2.
Graphically, indicate how much cash this plan would have had to give the modeled
individual in order to increase his utility from indifference curve U1 to U2.
Which plan costs more, the first or second?
Which plan gets consumers to consume more units of education?
The first plan lowers the price of education via the subsidy. Thus, the budget constraint
pivots outward along the education axis. The new budget constraint under is labeled
BCA.
The new utility maximizing indifference curve is U2 on budget constraint BCA. Also, the
new utility maximizing consumption bundle is A with QA units of education.
Assuming the cost of good Y is $1.00 per unit, then the cost of the first plan is A2-A1
dollars, represented by the vertical distance from A1 to A2. To see this, note that the
vertical distance between BC1 and BCA at QA units of education is A2-A1. If the cost of
each unit of Y (on the vertical axis) is $1.00, then the vertical distance between A2 and
A1 represents the cost of the subsidy program. In other words, the government would

have to give the individual an amount of money equal to A2-A1 in order to make
consumption bundle A attainable.
To get to indifference curve U2 via more income with no relative price change, the
original budget constraint would have to shift outward until it becomes just tangent to the
new indifference curve (U2). This occurs at consumption bundle B on indifference curve
U2 with QB units of education. Again assuming the cost of a unit of Y is $1.00, the
increase in income needed to get to U2 under the original prices is the distance between
B2 and B1. This is the distance between the parallel lines BC1 and LineB. So, the
government would have to give cash equal to B2-B1.
B2-B1 is clearly less than A2-A1. So, the first plan costs more than the second plan.
The first plan gets the individual to consume more education (QA) than the second plan
(QB).
Good Y
b
a
A2

U2

B2

U1
A1, B1

BC1

LineB

BCA

QB QA
Units of Education
This illustrates the difference between targeted tax cuts and income tax cuts. It also
depicts different underlying philosophies about utility maximization whether consumers
can maximize their own utility or whether the government knows better how to maximize
consumers utility. This can be related to the charity example whether the homeless
person better knows how to maximize his utility or the charity organization.
Also, notice that if the amount spent on the subsidy was instead given to consumers, then
consumers would have been able to attain a higher level of utility on a higher indifference
curve. For example, would you rather have $100.00 worth of apples or $100.00 in cash?
Probably the $100.00 in cash, because it allows you to spend the gift any way you
choose.
So, would you rather have targeted tax cuts (like education subsidies) or an income tax
cut? Would you rather have $20.00 cash or $20.00 worth of food?

Problem Set 3
Effects

Substitution and Income

1. Figure 1 below represents Millards preferences for coke and deodorant. Initially at
point a, Millard consumes Q1 units of deodorant. However, the price of deodorant
has increased from p1 to p2. Millard now consumes equilibrium bundle b which
contains Q2 units of deodorant at a price of p2.
a)
According to Figure 1 below, are coke and deodorant substitutes or
complements?
b)
By what amount did Millards equilibrium consumption of deodorant fall as a
result of the price change?
c)
According to Figure 1, find the substitution effect of the increase in the price
of deodorant. Is the substitution effect positive or negative, and how large is it
in terms of quantity of deodorant?
d)
According to Figure 1, find the income effect of the increase in the price of
deodorant. Is the income effect positive or negative and how large is it in
terms of quantity of deodorant?
e)
Is deodorant a normal or an inferior good? How do you know?
f)
According to Figure 1, when the price of deodorant went up from p1 to p2, did
total expenditures on deodorant increase or decrease?
Coke

Figure 1

c
a
b
BC2
Q2

BC1
Q3 Q1

Deodorant

2. Suppose in Alaska the price of a winter coat had been $100 at a local outdoor clothier.
However, the price of coats has decreased to $50. Assume there has been no change
in tastes. The indifference map below graphs the effect of the price change of a coat
described above. Coats are graphed on the horizontal axis of the diagram with snow
tires on the vertical axis.
a) According to the diagram, are coats and snow tires substitutes or complements?
b) Identify the size of the substitution effect. What is the sign of the substitution
effect?
c) Identify the size of the income effect. What is the sign of the income effect?
d) Identify the size of the total effect. What is the sign of the total effect?
e) In this example, are coats a normal or inferior good?

f) For this part of the question, assume coats are an inferior good. Assuming coats
are an inferior good, what would the sign of the substitution effect and income
effect be to an increase in the price of winter coats?
Snow Tires

A
B
C

BC1
QA

QC

QB

BC2
Coats

3. One of President Clinton's goals for 1998 is to pass legislation to make child care
more affordable. Suppose President Clinton uses government subsidies to reduce the
price of a unit of childcare. Let a unit of childcare be an hour of childcare per child.
a) Do you think a unit of childcare is a normal or inferior good? Explain your
answer.
b) Using an indifference map complete with budget constraint, graph the effect of a
decline in the price of a unit of childcare (keeping in mind what kind of good you
believe a unit of child care to be). Graph units of child care on the horizontal axis
and composite consumption good "C" on the vertical axis.
c) Using your diagram drawn in part b, decompose the effect of Clinton's childcare
subsidy that you have drawn into the substitution and income effect. Explain your
additions to your diagram. State whether the substitution and income effects are
positive or negative. Your answers and graphical additions should correspond
correctly with your answer to part a.
d) According to your diagram, did the modeled consumer's expenditures on units of
child care increase or decrease when the price of a unit of childcare decreased.
Explain briefly.

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Answer Key #3
Income Effects

Substitution and

Answer to question 1.
Complements because when PD increases, deodorant decreases and coke
a)
decreases.
A to B or Q2 Q1
b)
A to C or Q3 Q1, which is negative {-}.
c)
C to B or Q3 Q2, which is negative {-}.
d)
Deodorant is a normal good because a decrease in real income results in less
e)
deodorant being consumed (because the income effect of a price increase is
negative).
Increase. The budget constraint is given by: I = PCC + PDD. Income (I) and
f)
PC stay constant, coke decreases, so total expenditures on coke decrease. The
price of deodorant increases and deodorant decreases, so the change in the
total expenditure on deodorant appears to be ambiguous. But, if income did
not change, and if were spending less on coke, then weve got to be spending
more on deodorant.
Answer to question 2.
a) Snow tires and winter coats are substitutes: when the price of winter coats goes down,
more winter coats are consumed but fewer winter tires are consumed. Consumers
appear to be substituting snow tiers with winter coats. This shown by the movement
from consumption bundle A to bundle B as the price of winter coats increases.
Bundle B contains more winter coats and fewer snow tires.
b) The substitution effect shows how consumers respond to a relative price change
without a change in real income. From point A to Point C, there has been a relative
price change but no change in purchasing power: the substitution effect is QA to QC
and its positive.
c) The Income effect shows how consumers respond to a change in real income with
relative prices remaining the same. From point C to point B there has been a change
in real income but no change in relative prices because the dotted line and budget
constraint BC2 have the same slope: the income effect is QC to QB and its positive.
d) The total effect is the combined substitution effect and income effect. The total effect
is what we actually observe: QA to QB and its positive.
e) When the price of a good goes down, normal goods have positive substitution,
income, and total effects; inferior goods have positive substitution and total effects
and negative income effects. Here, winter coats are a normal good.
f) If winter coats had been an inferior good and the price of winter coats increased, then
there would have been a negative substitution effect, a positive income effect and a
negative total effect (the substitution effect would have been bigger).
Answer to question 3.
a)
Any thoughtful answer to part a is fine. Ill do the key for childcare being a
normal good and then an inferior good.

11

Let Childcare be a normal good. BC2 reflects the subsidy, which reduces the real
price of childcare.
C

A
B
C

BC1

BC2

Substitution Effect {+}

Income Effect {+}
Total Effect {+}
b)
c)

d)

When the real price of childcare declines, we observe a movement from point
a to point b on BC2. This is the total effect and it is positive.
The substitution effect is from point a to point c. Point c represents optimal
consumption under the new relative prices but the no change in real income.
The substitution effect is positive. The income effect is from point c to point
b. This shows the reaction of a consumer to a change in real income. There
has been no change in relative prices between point c and point b. The
income effect is positive and the total effect is positive (TE = SE + IE).
I = PCCCC + PC C. Income remains constant. Total expenditures on C
decrease because PC is constant and C decreases. Therefore, total
expenditures on CC went up.

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Now let Childcare be an inferior good. BC2 reflects the subsidy, which reduces the real
price of childcare.
C
B
A
C

BC1

BC2

Substitution Effect {+}

Income Effect {-}
Total Effect {+}
e)
f)
g)

When the real price of childcare declines, we observe a movement from point
a to point b on BC2. This is the total effect and its positive.
The substitution effect is from point a to point c. The substitution effect is
positive. The income effect is from point c to point b. The income effect is
negative and the total effect is positive (TE = SE + IE).
I = PCCCC + PC C. Income remains constant. Total expenditures on C increase
because PC is constant and C increases. Therefore, total expenditures on CC
went down.

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