ECON7870 Chap.7 Price Changes, Demand and Welfare
Price Changes, Demand and Welfare
Split one observed movement into two causes
A price change alters relative prices and real purchasing power. The substitution effect moves along a fixed utility level toward the relatively cheaper good. The income effect moves from that compensated bundle to the final Marshallian choice.
Their sum is the total demand response.
Measure welfare with expenditure
Compensating and equivalent variation turn utility comparisons into money by pricing a reference utility at specified prices.
The reference must be named before calculating, because switching old and new utility answers a different question.
Predict the two arrows
After an own-price fall, the substitution effect raises demand for the cheaper good. The income effect raises demand for a normal good but reduces demand for an inferior good. A Giffen case requires that opposing income movement to dominate.
Stating both arrows before algebra keeps inferiority from being mistaken for upward-sloping demand.
Name what stays fixed
Marshallian demand holds nominal income fixed. Hicksian demand holds utility fixed by adjusting expenditure. An Engel curve changes income at fixed prices, while a cross-price effect changes another good's price.
Put the maintained condition in the first sentence of a graph interpretation so visually similar curves are not treated as the same object.
Report money transfers in plain language
Welfare sign conventions vary, so say whether money must be given after a loss or could be removed after a gain while preserving the reference utility. That sentence makes the result unambiguous.
Finally check direction: higher prices cannot lower the expenditure required to reach the same utility under ordinary consumer theory.
Build the decomposition in checkpoints
Record the initial choice, the compensated choice and the final choice in that order. The first arrow holds utility fixed and responds only to the new relative price; the second holds new prices fixed and releases the compensation.
For the good whose price falls, substitution must point toward greater consumption. The income arrow then depends on whether the good is normal or inferior. State the two changes separately before adding them. When measuring welfare, name both the reference utility and the prices used to value it, then describe the transfer in words so a sign convention cannot reverse the conclusion.
What this chapter covers
- 01
Income effects
- 02
Substitution effects
- 03
Normal goods
- 04
Inferior goods
- 05
Slutsky decomposition
- 06
Compensated demand
- 07
Compensating variation
Worked example · free
Value a price improvement
- 3Find original utility and the new optimum.
- 3Price original utility at the new prices.
- 2State the removable amount and sign convention.
Key terms
- Substitution Effect
- The quantity response to a relative price change while utility is held fixed.
- Income Effect
- The quantity response caused by the change in real purchasing power after a price movement.
- Normal Good
- A good whose demand rises when income rises, other determinants held fixed.
- Inferior Good
- A good whose demand falls when income rises, other determinants held fixed.
- Compensating Variation
- The money transfer after a change that restores the consumer's original utility.
Price Changes, Demand and Welfare FAQ
Why does a price change have two effects?
It changes the rate at which goods trade in the market and changes the purchasing power of nominal income. Hicksian compensation isolates the first movement at fixed utility. The remaining movement to the final Marshallian bundle is the income effect.
Can an inferior good still have downward-sloping demand?
Yes. After an own-price fall, substitution raises demand while the income effect for an inferior good lowers it. Demand remains downward sloping when substitution is larger. A Giffen case requires the opposing income effect to dominate, so inferiority alone is insufficient.
Why state a welfare sign convention in words?
Different texts attach signs to money received or money removed in different ways. Saying that a stated amount must be given after a loss, or could be taken after a gain, makes the economic meaning unambiguous even when notation differs.
Exam move
Draw old, compensated and new budget lines, then label the two movements before using a formula. For welfare measures, write a sentence naming the reference utility and price vector. Check that a price increase cannot reduce expenditure required for the same utility.
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