When analyzing the price-consumption curve, we consider the impact of price changes on the replacement of one good with another. A decrease in the price of a product will have two effects. The substitution effect is the replacement of one good with another due to a change in their relative prices. A decrease in the price of a good causes an increase in the volume of demand for it. A lower price for one good, with constant prices for other goods, increases its attractiveness and encourages consumers to replace this good with others that turn out to be relatively more expensive. The income effect is a change in the consumer's real income due to a change in the price of consumed goods. If the consumer’s money income is unchanged, then an increase in prices means a decrease in real income, which expresses the actual amount of goods that can be purchased with the available money income.

In microeconomic theory, there are two approaches to distinguishing the income effect and the substitution effect: in accordance with the theory of J. Hicks and E.E. Slutsky. The existence of these approaches is explained by the specific interpretation of real income by these economists. According to J. Hicks, different levels of monetary income that provide the same level of satisfaction, i.e. allowing to achieve the same indifference curve represent the same level of real income. According to E.E. Slutsky, only the level of monetary income that is sufficient to purchase the same set or combination of goods ensures a constant level of real income. We will consider a more general version proposed by Hicks. The effects manifest themselves differently depending on the type of product.

The substitution effect and the Hicks income effect for a normal good. When the price of a good decreases, the consumer has the opportunity to move to a higher indifference curve due to an increase in real purchasing power. This means that, firstly, the consumer can buy the same amount of goods by spending less money; secondly, he will consume more of the good that has become cheaper and less of the good that has now become relatively more expensive. Typically, these two processes occur simultaneously, but are different from each other. In Figure 5.12, and the consumer chooses a set of goods A on the original line of the budget constraint A A.” If the price of the product X falls, then decrease B x will turn the budget constraint to position A"B" and the consumer will be able to purchase a product set corresponding to the point IN. However, if when the price of a product falls X At the same time, the consumer's income will decrease, then the line of the budget constraint will move out of position^ IN" to position СС" and the consumer’s maximum utility bundle will correspond to the point WITH on the original indifference curve.

Rice. 5.12. Hicksian income and substitution effects for normal goods: A- prices are reduced; b- prices are rising

Thus, moving along an indifference curve 1/° from point A to the point WITH represents the substitution effect. Reducing the price of a product X forces the buyer to replace more goods X for a smaller quantity of goods U. Moving consumption from point WITH to the point IN expresses the income effect. The total effect of lowering the price of a good is equal to the sum of the substitution and income effects. For normal goods, these effects act in one direction (opposite to the price change). The income effect and the substitution effect for a normal product in the case of a price increase are presented in Fig. 5.12, b .

Hicksian income and substitution effects for inferior goods. Figure 5.13 illustrates the effect of substitution and income effects, provided that the product X is of poor quality. In this case, the substitution effect is negative. The consumer adapts to the price reduction by consuming more of the product in his bundle X, moving away from A to C. However, the overall effect is that the point IN is located to the left of point C. The income effect led to the fact that the individual began to buy less goods X. Here the income effect counteracts the substitution effect. If the magnitude of the income effect does not exceed the substitution effect, then the overall effect corresponds to the action of the law of demand, as shown in Fig. 5.13, a.

Rice. 5.13. Hicks income and substitution effects for low-quality goods (prices go down): A- with a relatively small income effect; b- with a relatively large income effect (Giffen goods)

The English economist R. Giffen drew attention to the fact that during the famine in Ireland in the middle of the 19th century. The volume of demand for potatoes increased significantly with rising prices, which completely contradicts the classical formulation of the law of demand. This phenomenon is called the “Giffen Paradox,” which is explained by economists as follows: “potatoes were the staple food of the Irish poor. The increase in its price forced them to reduce the consumption of other, more expensive and high-quality products. Since potatoes nevertheless remained comparatively the cheapest product, the volume of demand for it increased... such a situation represents the only possible exception to the general law of demand.”

A Giffen good is a good that occupies a large place in the budget of low-income consumers, the demand for which, other things being equal, changes in the same direction as the price, since the income effect exceeds the substitution effect. This situation is graphically depicted in Fig. 5.13, b. The substitution effect leads to a relatively small increase in consumption of the good (from A to C), but the income effect has a larger downward effect on the consumption of the product Hot C to IN. Thus, if, when the price of a low-quality good changes, the income effect turns out to be stronger than the substitution effect, then the law of demand will be violated.

Test questions and assignments

• 1. What is consumer behavior in the market? What are the basic premises of the theory of consumer behavior?
• 2. What are the differences between cardinalist and ordinalist theories of consumer behavior?
• 3. Explain the difference between marginal and total utility.
• 4. How are the graphs of total and marginal utility related to each other?
• 5. Formulate the law of diminishing marginal utility and explain the mechanism of its action.
• 6. Formulate a rule for maximizing utility.
• 7. Why is it impossible to compare the absolute values ​​of the marginal utilities of different goods when considering the maximization of benefits for the consumer?
• 8. Explain what the substitution effect and the income effect are from the point of view of marginal utility theory.
• 9. Can you explain the downward sloping nature of the demand curve based on the law of diminishing marginal utility?
• 10. What is consumer surplus and how does it arise? Explain this with a graph.

Let's consider four stages of decomposition of the total effect of a price change into the substitution effect and the Hicks income effect (Fig. 8.28) (the above model considers a situation in which a price change leads to a shift in the budget line to a position that does not ensure the achievement of the maximum possible satisfaction).

Rice. 8.28.

The price of product X decreases

• 1. Determination of the initial optimum of the consumer.AB ]- the original budget line. Her touch with the indifference curve Ux E ( , X in volume X ( .
• 2. Determination of the consumer's optimum when the price of one product changes. In case of price reduction X budget line ( AB,) will take the position AB T Her touch with a higher indifference curve U 2 determines the consumer's optimum at the point E 2, which corresponds to the consumption of goods X in volume X t Thus, the overall result of reducing the price of a product is X is expressed in an increase in its consumption from X ( to X 2.
• 3. Let us establish what the consumer’s monetary income should be in order to provide him with the same level of satisfaction (i.e., the same level of real income) with a changed price ratio. To do this, we will conduct an auxiliary budget direct line A x B y parallel to the line AB 2(i.e. reflecting the new price ratio), so that it touches the indifference curve Uv The tangent point determines the auxiliary optimum of the consumer at the point E y X y
• 4. E ( To E b) the consumer's real income does not change, he remains on the same indifference curve Uv Therefore, the shift from E ( To E 3 Y X. It is equal to the difference X 3 - X y When moving from E ъ To E 2 E 3 To E 2 X. It is equal to the difference X 2 - X y

Model of decomposition of the total effect of price changes into the substitution effect and the income effect according to E.E. Slutsky Let's consider stages of decomposition of the total effect of price changes into the substitution effect and the income effect according to Slutsky(Fig. 8.29).

Rice. 8.29. Substitution effect and income effect according to Slutsky.

The price of product X decreases

• 1-2. Similar to the Hicks approach.
• 3. Determination of the auxiliary optimum of the consumer. Let us establish what the consumer’s monetary income should be in order to provide him with the same set of goods (i.e., the same level of real income) with a changed price ratio. To do this, we will conduct an auxiliary budget direct line A (B y parallel to the line DX 2(i.e. reflecting the new price ratio), through the point E y Budget direct AB 3 will be tangent to something higher than U., indifference curve U y The tangent point determines the auxiliary optimum of the consumer E y which corresponds to the consumption of goods in the volume X y
• 4. Determination of the income effect and the substitution effect. During the transition from the initial to the auxiliary optimum (from E ( To E 3) the consumer's real income does not change, since the transition occurs along the auxiliary budget line. Therefore, the shift from E 1 To E 3 characterizes the effect of product substitution Y relatively cheaper goods X. It is equal to the difference X 3 - X y

When moving from E 3 To E 2 the price ratio does not change. Therefore, the shift from E 3 To E 2 characterizes the income effect from a decrease in the price of a product X. It is equal to the difference X 2 - X y

Having compared two approaches (Hicks and Slutsky) to solving the problem, we can draw the following conclusions (Fig. 8.30): when the price decreases, Slutsky’s auxiliary budget direct line ( A 2 B 4) is always higher than the auxiliary budget Hicks straight line, since the first is a secant to the original indifference curve, and the second is a tangent to it (A X B 3). Therefore, the substitution effect according to Slutsky is always greater than the substitution effect according to Hicks, and the income effect according to Slutsky is always less than the income effect according to Hicks.

Rice. 8.30.

Above we considered the situation when the price of a product decreases. Below are graphs (Fig. 8.31, 8.32) showing the substitution effect and the income effect when the price of a product increases.

In Fig. 8.31 shows the decomposition of the total effect of increasing the price of a product X on the substitution effect and the Hicks income effect. The overall effect of an increase in the price of a product X X ( to X 2. The substitution effect is equal to X x - X y and the income effect is X 3 - X g

In Fig. Figure 8.32 shows the decomposition of the total effect of increasing the price of a product X on the substitution effect and the income effect according to Slutsky. The overall effect of an increase in the price of a product X leads to a decrease in the consumption of this product from X ( to X 2. The substitution effect is equal to X x - X 3, and the income effect is X 3 - X t

Rice. 8.31. The substitution effect and the Hicks income effect. Product price X rises

Rice. 8.32.

CONSUMER SURPLUS

The meaning of consumer surplus is as follows: the consumer pays the same price for each unit of goods, equal to the marginal utility of the last, least valuable unit for him. This means that for each unit of goods preceding this last one, the consumer receives some benefit.

Thus, consumer surplus- This:

• the difference between the estimate of the marginal utility of each unit of a good and the market price;
• the difference between the amount of money that a consumer would be willing to pay and the amount that he actually paid.

Let's depict consumer surplus graphically (Fig. 8.33).

Rice. 8.33. Consumer surplus

On the graph, consumer surplus is the area bounded above by the demand curve and below by the price line. The lower the price, the greater the consumer surplus.

The Hicks decomposition of the total effect of a price change into the income effect and the Hicksian substitution effect is as follows. The budget line KL corresponds to money income I and prices P x and P Y . Its tangency with the indifference curve U 1 U 1 determines the optimum of consumer E 1, which corresponds to the volume of consumption of product X in quantity X 1. In the case of a decrease in the price of X to P X1 and constant monetary income I, the budget straight line will take the position KL 1. It concerns a higher indifference curve U 2 U 2 at point E 2, which corresponds to the consumption of product X in volume X 2. Thus, the overall result of a decrease in the price of good X is expressed in an increase in its consumption from X 1 to X 2 Hicks J.R. Cost and capital. / Per. from English M., 2013. P.115..

The substitution effect and the Hicks income effect.

Now let’s determine what the consumer’s monetary income would have to be in order to provide him with the same level of satisfaction given the changed price ratio. To do this, we will draw an auxiliary budget straight line K"L", parallel to the line KL 1 (i.e., reflecting the new price ratio), so that it touches the indifference curve U 1 U 1 (i.e., would ensure the same level of satisfaction). Let us note the point of contact E 3 and the corresponding volume of consumption of product X 3 Ibid. P.117..

Note that when moving from the initial to the additional (calculated) optimum (from E 1 to E 3), the consumer’s real income does not change, it remains on the same indifference curve U 1 U 1 . This means that the shift from E 1 to E 3 characterizes the effect of replacing product Y with a relatively cheaper product X. It is equal to the difference X 3 - X 1. Therefore, the income effect will be X 2 - X 3. Note also that, as a result of the income effect, the consumption of both goods at point E 2 is higher than at point E 3.

Substitution effect and Hicks income effect

The same decomposition of the total effect can be performed for the case when the price of product X rises. Here, the result of a price increase is to move the consumer's optimal position to a lower indifference curve U 1 U 1 . The overall effect of increasing the price of good X is to reduce its consumption from X 1 to X 2. In this case, the substitution effect will be X 1 - X 3, the income effect - X 3 - X 2. Note that in both cases, the substitution effect is characterized by a movement along the same indifference curve, and the income effect is characterized by a transition from one curve to another. Lebedev A.V. Non-classical examples of utility functions // Vestnik Mosk. Univ. Ser. 6. 2014. No. 5. P.107.

The substitution effect is always negative. A decrease in the price of one good encourages the consumer to increase its consumption by reducing the consumption of another good (or group of goods). An increase in price encourages him to replace this product with other, relatively cheaper ones. The income effect can be negative for normal goods, positive (in the case of an inferior good, when the income-consumption curve has a negative slope), or neutral (if the income-consumption curve is vertical). In our examples, the income effect enhances the substitution effect by increasing consumption of good X when its price decreases and reducing consumption when its price increases. For low-quality goods, the income effect is positive - the higher the real income, or purchasing power, of the consumer, the less inclined he will be to purchase such a product. However, for most inferior goods, the negative substitution effect offsets the positive income effect, so the overall effect of the price change will still be negative. So, in the figure (it shows only the budget lines KL and KL 1 and the auxiliary line K "L", the points of their tangency with the indifference curves omitted in the figure are designated E 1 - E 3, respectively) the general result of an increase in the price of goods X (X 1 - X 2) decomposes into the substitution effect X 1 - X 3 and the income effect X 3 - X 2, while (X 1 - X 3) > (X 3 - X 2) Hicks J.R. Four consumer surpluses. / Per. from English // Theory of consumer behavior and demand. St. Petersburg, 2013. P. 194..

Substitution effect and income effect. The price of X increases, and - low-quality goods; b - Giffen goods

Therefore, as a rule, demand curves for such goods usually have a negative slope, as in the case of normal goods. Only if the positive effect of income covers the negative effect of substitution, the law of demand is violated - its volume changes in the same direction as the price. Such goods are called Giffen goods. In reality, the consumption of most goods requires only a small portion of the consumer's income and the income effect is usually small. Even if it is negative, its size is not sufficient to cover the influence of the substitution effect. Therefore, the emergence of Giffen products is unlikely.

Sir John Richard Hicks (1904-1989) - English economist. Winner of the 1972 Nobel Prize (jointly with K. Arrow) “for innovative contributions to the general theory of equilibrium and the theory of welfare.” Studied at Oxford; received a Master of Arts (M.A.) and taught there, as well as at the London School of Economics and the University of Manchester. His wife, Lady Ursula K. Webb, daughter of the famous Fabians Sidney and Beatrice Webb, was the author of a number of famous works, including Public Finance in National Income (1939), co-authored with her husband.

Hicks's range of scientific interests was quite wide, but he paid his main attention to the study of the fundamental problems of modern economic science - issues of cost, supply and demand, price, wages, capital and profit, economic growth, cyclical development, inflation. Hicks's first major work was “ Theory of wages" - is devoted to the study of the functioning of the labor market and the mechanism for setting wages in conditions of imperfect competition. Here the scientist outlined his theory of industrial conflict, according to which the theory of wage setting is a special case of the general theory of value, and the main factor that disrupts the free interaction of market forces in the labor market are trade unions. Within the framework of this theory, Hicks tried to prove that pay rates are determined by the intersection of the “concession curve” of entrepreneurs and the “resistance curve” of trade unions, put forward the idea of ​​​​the possibility of substituting labor with capital and the elasticity of such substitution, and defined the neutrality of technical progress, in which innovation does not lead to changing the proportions of product distribution between factors of production. Hicks's work had a significant influence on the subsequent development of production function theory and neoclassical theories of unemployment, in particular the theory of the natural rate of unemployment. In Hicks's main work - the book "Cost and Capital" - for the first time since A. Marshall, an attempt was made to consistently analyze the foundations of neoclassical theory. "Cost and Capital" is considered a classic exposition of general equilibrium theory. The IS-LM model (savings for investment - money market) he proposed received recognition and was included in educational literature. The book stands out for the breadth of problems considered and lays the foundations of modern microeconomic theory. The work outlines the foundations of the ordinalism theory of prices and develops the fundamental principles of the general theory of equilibrium. Hicks first raised the question of the stability of competitive equilibrium in large economic systems and proved that many of the most important concepts of the Ausserian subjective theory of value, such as the law of diminishing utility, the measurability of the absolute value of utility, etc., are in fact not related to fluctuations in demand and supply on the market. Hicks made a significant contribution to the theory of cyclical development. The scientist abandoned the psychological concepts of the cycle by A. Ligu and other representatives of the Cambridge school and proposed a theoretical scheme of the cycle, in which he identified 4 main phases. In his interpretation, the cycle is a set of deviations from the equilibrium trajectory of economic development. Hicks’s concept of inflation is most fully outlined in Essays on the World Economy and comes down to the introduction of the concept of “labor standard” and the thesis of the “wages-prices” spiral. In “The Theory of Economic History,” Hicks develops the idea of ​​interconnectedness and conditionality of economic processes. In the 1970s, Hicks paid much attention to the development of methodological problems in the development of economic theory and the revision of Keynesian economic theory. In “The Crisis in the Development of Keynesian Theory,” he clarified and supplemented Keynes’s constructions and statements, abandoned a number of important provisions of his theory and tried to adapt Keynes’s theory to modern conditions, becoming the founder of “Hicksian Keynesianism.”

It is worth saying that the position on the decomposition of the general effect of price changes into the substitution effect and the income effect was first put forward by the Russian economist, mathematician and statistician Evgeniy Evgenievich Slutsky (1880–1948). In 1915, he published an article in the Italian economic journal “Towards the theory of a balanced consumer budget” . By the way, this article was “discovered” in the 30s. English economist, mathematician and statistician R. Allen. The English economist J. Hicks speaks about the priority of scientific research on this problem by E. Slutsky in his work “Cost and Capital”, in which he points out that the theory of consumer behavior developed by him in collaboration with R. Allen “essentially belongs to Slutsky, with that only with the caveat that I was completely unfamiliar with his work, either at the time of completing his own research, or even for some time after the publication of the contents of these chapters in the journal Economics by R. Allen and myself.

The approaches of Slutsky and Hicks to determining real income differ. According to Hicks, different levels of money income that provide same level of satisfaction represent the same level of real income. According to Slutsky, only the level of monetary income that is sufficient to acquire the same set or combination of goods, provides a constant level of real income.

Hicks's approach is more consistent with the basic principles ordinal theory. Slutsky's approach makes it possible quantitative solving problems based on statistical data.

Substitution effect and income effect according to Slutsky

A graphical model of the decomposition of the total effect of price changes into the substitution effect and the income effect according to Slutsky is shown in Fig. 11.1.

Figure No. 11.1

In Fig. Figure 11.1 shows normal (full-value) goods, the demand for which increases with income growth. Based on this, when real income decreases, the resulting component in the Slutsky equation is negative. The sum of two negative quantities is also negative, so the overall result of increasing prices for normal goods is to reduce the volume of demand for them. The influence of the substitution effect and the income effect is unidirectional, as we see in Fig. 11.1.

In Fig. Figure 11.2 shows neutral goods. In the case when the consumer considers a given good to be neutral, when income changes, the demand for such a good does not change, and the income effect is zero. The overall change in consumption of this good coincides with the substitution effect. In this case, the slope of the demand curve will be steeper compared to the slope of the demand curve for a normal good (see Fig. 11.1)

Figure No. 11.2

In Fig. Figure 11.3 shows a graph of an inferior good, the demand for which decreases with income growth, but the absolute value of the income effect is less than the value of the substitution effect. The overall result of the price increase will be negative, although it will be even smaller in absolute value than in the case of neutral goods.

Figure No. 11.3

In the case of an inferior good, when the substitution effect and the income effect are equal in absolute value, the demand for such an inferior good will be absolutely inelastic(Fig. 11.4)

Figure No. 11.4

In this case, the law of demand continues to operate, but its influence is neutralized by an equivalent decrease in real income for inferior goods.

When the absolute value of the income effect when the price of a less valuable good changes exceeds the value of the substitution effect, then the overall effect of the price increase becomes positive.

Such a good is called a Giffen good, and the demand curve for this good has a positive slope (Fig. 11.5)

Figure No. 11.5

Substitution effect and Hicks income effect

Let us study the division of the total effect of a price change into the substitution effect and the Hicks income effect using the example of two options: a) in the case of a price decrease; b) in case of price increase. Let's start with the first option.

The decomposition of the total effect of a price change into the income effect and the substitution effect is illustrated in Fig. 11.6. The budget line KL ϲᴏᴏᴛʙᴇᴛϲᴛʙ represents money income I and prices P x and P Y . The tangency of the budget line of the indifference curve U 1 U 1 at point E 1 characterizes the consumer’s optimum, which demonstrates the volume of consumption of goods X in quantity X 1. With constant monetary income I and with a decrease in X to P X1, the budget line will take the position KL 1. It is worth noting that it concerns the higher indifference curve U 2 U 2 at point E 2, which represents the consumption of good X in volume X 2. Consequently, the overall result of a decrease in the price of good X is expressed in an increase in its consumption from X 1 to X 2.

Figure No. 11.6. The substitution effect and the Hicks income effect. The price of X decreases

To determine what the consumer's monetary income should have been to maintain the same level of satisfaction when prices fell, let's construct an auxiliary budget line K"L" (Hicks line), parallel to the KL 1 line; which will simultaneously be tangent to the indifference curve U 1 U 1 at point E 3, which corresponds to the volume of consumption of good X 3. When moving from the initial to the additional optimum (from E 1 to E 3) the consumer’s real income remains unchanged, remaining on the same indifference curve UjUj. Based on all of the above, we come to the conclusion that the shift from E 1 to E 3 demonstrates substitution effect good Y is relatively cheaper good X. It is worth noting that it is equal to the difference X 3 – X 1; A income effect will be X 2 – X 3. The income effect leads to an increase in consumption of both goods at point E 2 in comparison with point E 3.

Let's move on to the second option for dividing the total effect, when the price of good X rises (Fig. 11.7). An increase in price causes the consumer's optimal position to move to a lower indifference curve U 1 U 1 . The overall effect of an increase in the price of good X is to reduce its consumption from X 1 to X 2. In this case substitution effect will be X 1 – X 3, and the income effect is X 3 – X 2.

Do not forget that it will be important to say that in both cases the substitution effect is shown by movement along the same indifference curve, and the income effect is shown by movement from one indifference curve to another.

The substitution effect will always be negative: a decrease in the price of one good stimulates consumers to increase its consumption, reducing the consumption of another good; an increase in price stimulates consumers to replace the good with others that are relatively cheaper.

Figure No. 11.7. The substitution effect and the Hicks income effect. The price of X rises

The income effect can be negative for full-fledged goods, positive - for inferior goods, neutral - when the demand for a good does not change with a change in income and the income effect is zero.

Comparing the approaches of Slutsky and Hicks regarding the division of the total effect into the substitution effect and the income effect, the following conclusions can be drawn.

1. Hicks’ methodology allows for knowledge of consumer preferences and indifference curves, while Slutsky’s methodology does not require this, since it is based on facts of consumer behavior in the market.

2. Hicks's methodology is based on the basic principles of the ordinal, or ordinal, theory of marginal utility. Slutsky's methodology is based on the quantitative, or cardinalist, theory of marginal utility.

3. Slutsky used a less strict from the standpoint of utility theory, but more pragmatic method of determining a given level of real income.

4. According to Slutsky’s methodology, the intermediate budget line most often touches an indifference curve higher than the original one, which is what is required according to the Hicks methodology. According to Slutsky, the consumer, having the opportunity to purchase the same set of goods as before the price change, will find himself at a higher level of well-being than before the price change.

SLUTSKY Evgeniy Evgenievich (1880–1948), Soviet economist, mathematician and statistician, founder of the mathematical theory of consumption. Based on the developments of foreign economists (V. Pareto, F. Edgeworth, etc.), he connected the utility function, which characterizes consumer preferences, with price dynamics and the amount of cash income of consumers.

He received his education at various educational institutions. First he studied at the mathematics department of Kyiv University, then at the mechanical engineering department of the Munich Polytechnic, and in 1911 he graduated with a gold medal from the law faculty of Kyiv University.

The scope of his work is equally diverse: a professor at a number of universities in Kyiv, the Market Research Institute of the Central Statistical Office of the USSR (Moscow), the Research Institute of Mathematics and Mechanics at Moscow State University, the Mathematical Institute. V. A. Steklova.