Edited by Mark Blaug and Peter Lloyd
Chapter 5: Substitution and Income Effects
5. Substitution and income effects Hans Haller Changes in market conditions or taxes may affect a consumer’s budget constraint. The consumer’s response to a change of the budget constraint is of theoretical and practical relevance. But in general, it proves difficult if not impossible to determine how the consumer’s demand is affected by a new budget situation. With n goods, a consumption bundle is represented by an n-dimensional vector of the form x 5 (x1, . . ., xn) and a price system assumes the form p 5 (p1, . . ., pn) . Moreover, a number m . 0 stands for the consumer’s nominal income or wealth. Attention will be confined to price–income pairs (p, m) that give rise to a unique bundle x 5 f (p, m) demanded under the corresponding budget constraint. Then the comparative statics question of how the consumer responds to a change of the budget constraint can be formulated as follows: Suppose an original budget situation (A) given by the price–income pair (p,m) and demand xA 5 f (p, m) and a new budget situation (C) given by the price– income pair (pr, mr) and demand xC 5 f (pr, mr) What is the total effect TE 5 xC 2 xA? The answer is easy if the numerical values of xA 5 f (p, m) and xC 5 f (pr, mr) are explicitly given and easily computed. A greater challenge occurs if the numerical values are unknown or hard to obtain. Then little can be said about the total...
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