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Income and Substitution Effect

The document discusses several applications of income and substitution effects, including: 1) An increase in income versus a subsidy on one product only, where an income increase makes the consumer better off by allowing them to purchase more of all goods. 2) Consumption over time, where saving refers to consumption in a future period and an increase in the interest rate incentivizes more saving by making future consumption relatively cheaper. 3) Labour versus leisure choices, where an increase in wages has both substitution and income effects on labour supply depending on whether leisure is seen as a normal or inferior good.

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Prajol Joshi
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181 views

Income and Substitution Effect

The document discusses several applications of income and substitution effects, including: 1) An increase in income versus a subsidy on one product only, where an income increase makes the consumer better off by allowing them to purchase more of all goods. 2) Consumption over time, where saving refers to consumption in a future period and an increase in the interest rate incentivizes more saving by making future consumption relatively cheaper. 3) Labour versus leisure choices, where an increase in wages has both substitution and income effects on labour supply depending on whether leisure is seen as a normal or inferior good.

Uploaded by

Prajol Joshi
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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INCOME AND SUBSTITUTION EFFECTS: APPLICATIONS

INCOME AND SUBSTITUTION EFFECTS: APPLICATIONS


Subsidy

on one product only v. Increase in income (at equal cost to government) Consumption v. Saving (Intertemporal choice) Labour v. Leisure

AN INCREASE in INCOME v. A SUBSIDY on ONE PRODUCT ONLY


Involves

equal cost to the government Example: food stamps used in the US for welfare recipients (Ireland: television licence, electricity, transport, )

AN INCREASE in INCOME v. A SUBSIDY on ONE PRODUCT ONLY


Budget constraint is given by
A p1 x1

A p2 x2

The government can

(1) give a subsidy on food (x1)

B p1 t x1B p2 x2 M

(2) give a increase in income


C p1 x1

C p2 x2

B tx1

Note: Equal cost to the government

AN INCREASE in INCOME v A SUBSIDY on ONE PRODUCT ONLY


But which makes the consumer better off ? X2

A U0 X1

AN INCREASE in INCOME v A SUBSIDY on ONE PRODUCT ONLY


But which makes the consumer better off ? X2 The subsidy on food leaves the consumer at B (better off than at A) B A U0 X1

U1

AN INCREASE in INCOME v A SUBSIDY on ONE PRODUCT ONLY


But which makes the consumer better off ? X2
A A p1 x1 p2 x2 M

The subsidy on food leaves the consumer at B (better off than at A) B A U0

U1
B p1 t x1B p2 x2 M

X1

AN INCREASE in INCOME v A SUBSIDY on ONE PRODUCT ONLY


To illustrate the equal cost nature of the the subsidy v. the income increase, you draw a line parallel to the original budget constraint which passes through the point B (as B must be affordable after the income increase).

AN INCREASE in INCOME v A SUBSIDY on ONE PRODUCT ONLY


But which makes the consumer better off ? X2 U2 C The increase in income leaves the consumer at C (better off than at B)

B A U0

U1

X1

AN INCREASE in INCOME v A SUBSIDY on ONE PRODUCT ONLY


But which makes the consumer better off ? X2 U2 C B A U0 The increase in income leaves the consumer at C (better off than at B)

U1
C C B p1 x1 p2 x2 M tx1

X1

CONSUMPTION v. SAVING
Persons

often receive income in lumps, e.g. monthly salary, yearly bonus, tax rebate ... How is a lump of income spread over the following month, year, (saving now for consumption later)? How is consumption financed by borrowing now against income to be received at the end of the month?

CONSUMPTION v. SAVING
Divide

time into two periods (today and tomorrow) Assume that a person has income in the first period only (today) Assume that a person consumes in both periods (today and tomorrow)

CONSUMPTION v. SAVING
1 Ct C t 1 Yt 1 i
This is equivalent to the budget constraint we met before, so we can apply the same techniques to analyse changes in consumption and saving.

p1 x1 p2 x2 M

Where Ct is consumption today, Ct+1 is consumption tomorrow, i is the interest rate and Y is income

CONSUMPTION v. SAVING
Divide

time into two periods (today and tomorrow) Assume that a person has income in both periods (today and tomorrow) Assume that a person consumes in both periods (today and tomorrow)

CONSUMPTION v. SAVING
With income in both periods the budget constraint looks like this

1 1 Ct Ct 1 Yt Yt 1 1 i 1 i
Income in period t and t+1

CONSUMPTION v. SAVING
1 Ct C t 1 Yt 1 i
1/ 1+i represents the current price of future consumption

1 1 Ct Ct 1 Yt Yt 1 1 i 1 i
represents the current price or value of future income 1/1+i

CONSUMPTION v. SAVING

Consumption tomorrow is called saving

CONSUMPTION v. SAVING
(Income in period t only)
1 Ct C t 1 Yt 1 i

What happens if the interest rate increases? Ct+1

(1+i)Yt

Yt

Ct

CONSUMPTION v. SAVING
(Income in period t only)
1 Ct C t 1 Yt 1 i

What happens if the interest rate increases? Ct+1 i


(1+i)Yt

The budget line pivots out from Yt

Yt

Ct

CONSUMPTION v. SAVING
(Income in period t only)
1 Ct C t 1 Yt 1 i

What happens if the interest rate increases? Ct+1 There is an increase in the value of i consumption tomorrow, i.e. the price of future (I+i)Yt consumption decreases

Yt

Ct

CONSUMPTION v. SAVING
(Income in period t only)
1 Ct C t 1 Yt 1 i

Ct+1

i
(I+i)Yt

Slope of the budget line = -(1+i*) Slope of the budget line = -(1+i)

Yt

Ct

CONSUMPTION v. SAVING
(Income in period t only)
1 Ct C t 1 Yt 1 i

Ct+1

Isolating the income and substitution effects

i
(I+i)Yt

b a

Yt

Ct

CONSUMPTION v. SAVING
(Income in period t only)
1 Ct C t 1 Yt 1 i

Ct+1

i
(I+i)Yt The substitution effect is a to b. Ct and Ct+1 ( St)

b a

Yt

Ct

CONSUMPTION v. SAVING
(Income in period t only)
1 Ct C t 1 Yt 1 i

Ct+1

i
(I+i)Yt

The income effect is b to c, usually Ct and Ct+1 ( St)

b c

Yt

Ct

CONSUMPTION v. SAVING
(Income in period t only)
1 Ct C t 1 Yt 1 i

Ct+1

Overall effect is unclear

Why? IE: Ct SE: Ct

i
C?? (I+i)Yt

Overall: ?Ct ?St

Yt

Ct

CONSUMPTION v. SAVING
(Income in both periods)

Ct+1

1 1 Ct Ct 1 Yt Yt 1 1 i 1 i

(1+i)Yt+Yt+1

Yt+1

(Yt,Yt+1)

Yt

Yt+1/ (1+i) Yt+1 Ct

CONSUMPTION v. SAVING
(Income in both periods)
1 1 Ct Ct 1 Yt Yt 1 1 i 1 i

Ct+1

A lender consumers less in period t than their income in period t (Ct<Yt) A lender type person

(1+i)Yt+Yt+1

Yt+1

Yt

Yt+1/ (1+i) Yt+1 Ct

CONSUMPTION v SAVING
(Income in both periods)
1 1 Ct Ct 1 Yt Yt 1 1 i 1 i

Ct+1

A borrower consumers more in period t than their income in period t (Ct>Yt)

(1+i)Yt+Yt+1

Yt+1

A borrower type person

Yt

Yt+1/ (1+i) Yt+1 Ct

CONSUMPTION v SAVING
(Income in both periods)
1 1 Ct Ct 1 Yt Yt 1 1 i 1 i

What happens if the interest rate increases? Ct+1 The budget constraint pivots around (Yt,Yt+1) and the outcome can be different for borrowers and lenders. (Yt,Yt+1) Yt+1

Yt

Ct

CONSUMPTION v SAVING
(Income in both periods)
1 1 Ct Ct 1 Yt Yt 1 1 i 1 i

What happens if the interest rate increases? Ct+1 LENDER

Yt+1

(Yt,Yt+1)

Yt

Ct

CONSUMPTION v SAVING
(Income in both periods)
1 1 Ct Ct 1 Yt Yt 1 1 i 1 i

What happens if the interest rate increases? Ct+1 LENDER


Utility is higher but we cannot be certain if Ct+1 or Ct rise or fall (Yt,Yt+1)

Yt+1
Yt

Ct

CONSUMPTION v SAVING
(Income in both periods)
1 1 Ct Ct 1 Yt Yt 1 1 i 1 i

What happens if the interest rate increases? Ct+1 LENDER


Could end up here (Yt,Yt+1)

Yt+1

Yt

Ct

CONSUMPTION v SAVING
(Income in both periods)
1 1 Ct Ct 1 Yt Yt 1 1 i 1 i

What happens if the interest rate increases? Ct+1 LENDER


Or here

Yt+1

(Yt,Yt+1)

Yt

Ct

CONSUMPTION v SAVING
(Income in both periods)
Ct 1 1 Ct 1 Yt Yt 1 1 i 1 i

What happens if the interest rate increases? Ct+1 BORROWER Utility is lower but.??

Yt+1

(Yt,Yt+1)

Yt

Ct

CONSUMPTION v SAVING
Do

the case of a decrease in interest rates. You can also show the income and substitution effects in the two period model.

LABOUR and LEISURE


Framework 24 hours a day There is only two things you can do with your time Work (paid labour market) Leisure Ignores housework (extension possible) You divide all you time between these two activities. When you work in the paid labour market, you are paid a market wage.

LABOUR and LEISURE


24.w = w.Leisure + p.Consumption

Where 24.w is the value of initial endowment, w.Leisure is the amount of the endowment spent on leisure and p.Consumption is the amount of endowment spent on consumption
Rearranging: C= 24w/p (w/p)Leisure

LABOUR and LEISURE


What happens if the wage rate increases? C

Slope = -w/p
24w/p

24h

Leisure

LABOUR and LEISURE


What happens if the wage rate increases? C W2 > W 1

24w2/p

w
24w1/p

The budget line pivots out from here

24h

Leisure

LABOUR and LEISURE


More labour or more leisure.? Use income and substitution effects C NB: Is leisure a normal or an inferior good?

w
24w1/p

24h

Leisure

LABOUR and LEISURE


More labour or more leisure.?

24w1/p

24h

Leisure

LABOUR and LEISURE


More labour or more leisure.?

Total Effect ?
C Depends (to some extent) on whether Leisure is assumed to be normal or inferior

w
24w1/p

24h

Leisure

LABOUR and LEISURE


More labour or more leisure.?

SE: A to B
C IE: Depends on whether Leisure is assumed to be normal or inferior

w
24w1/p

24h

Leisure

LABOUR and LEISURE


More labour or more leisure.?

SE: A to B
C IE: Depends on whether Leisure is assumed to be normal or inferior

w
24w1/p

24h

Leisure

LABOUR and LEISURE


More labour or more leisure.? Overall we could end up here if leisure is very normal

w
24w1/p

24h

Leisure

LABOUR and LEISURE


More labour or more leisure.?

SE: A to B
C IE: B to C

w
24w1/p

Depends on whether Leisure is assumed to be normal or inferior

24h

Leisure

LABOUR and LEISURE


Increase in wage rate Substitution effect: w price of leisure leisure and labour supply

Income effect: w income (value of the initial endowment) leisure and labour supply
IF LEISURE IS A NORMAL GOOD Overall effect: Leisure?? Labour Supply??

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