Question

Suppose a consumer has preferences between two goods that are perfect substitutes. Can you change prices in such a way that the entire demand response is due to the income effect?

Short answer

Change both goods' prices proportionally to see only the income effect without substitution.

Step-by-step solution

Understanding Perfect Substitutes

In the case of perfect substitutes, the consumer is indifferent between consuming one good over another. This means that the consumer will always choose the cheaper of the two goods. If both have the same price, the consumer might choose any combination of the two.

Consumer's Initial Choice

Assume the consumer initially consumes a combination of the two goods based on their budget constraint and the relative prices. If these goods are perfect substitutes, the consumer will choose the good with the lowest price.

Price Change Scenario

To investigate the demand response due to income effect alone, the price change must not cause the consumer to switch between goods purely based on the substitution effect. Thus, both goods need to have the price changed simultaneously in a proportional manner, keeping their relative price constant.

Effect of Proportional Price Change

If both prices increase or decrease in the same proportion, the relative attractiveness of the goods remains the same. Hence, no substitution occurs between goods based on relative prices. The consumer's choice under the new prices will only change due to the change in real income (income effect).

Analyzing the Income Effect

With the price increase or decrease, the consumer's real purchasing power changes. If prices increase proportionally, the consumer can afford fewer goods, purely reducing consumption due to the income effect. Similarly, if prices decrease, the consumer's ability to purchase increases due purely to the income effect.

Key concepts

Income Effect

The **Income Effect** refers to the change in an individual's consumption of goods as a result of a change in their real income. In simple terms, when the prices of goods rise or drop proportionally, the purchasing power of a consumer's income changes. For instance, if prices increase across the board, a consumer will feel poorer because their money doesn't buy as much anymore.

In the context of perfect substitutes, if both goods experience a price increase, but at the same rate, the relative attractiveness of these goods remains the same. The consumer experiences only an income effect without a substitution effect. Their overall ability to purchase either good is reduced purely because they have less purchasing power. Conversely, when prices decrease across the board, the opposite happens—the consumer can buy more of both goods due to increased purchasing power.

• The income effect solely relates to changes in real income rather than changes in preferences or choice between goods.
• When dealing with perfect substitutes, maintaining the same price ratio between two goods ensures that any adjustment in consumption is attributable entirely to the income effect.

Substitution Effect

The **Substitution Effect** is about how changes in relative prices of goods influence a consumer's choice between them. It's a basic economic principle where a consumer will switch from a good that has become relatively more expensive to one that is relatively cheaper. This assumes that all else, such as income and preferences, remain constant.

In the scenario with perfect substitutes, achieving a situation where the demand response is driven purely by the substitution effect would require altering the relative prices of the two goods. This means making one good cheaper or more expensive than the other. However, in exercises focused on isolating the income effect, both goods' prices are adjusted proportionally. Thereby keeping the substitution effect neutral.

• For perfect substitutes, the substitution effect is only present if the relative prices of the goods change.
• In practical terms, the substitution effect drives the decision to switch consumption between goods when one is relatively more affordable.

Budget Constraint

The **Budget Constraint** represents the combination of goods and services a consumer can purchase with their limited income. It plays an essential role in consumer choice, particularly when evaluating the effects of price changes on income and substitution effects.

Considering perfect substitutes, initial decision-making is guided by which good fits best within the consumer's budget while fulfilling their preferences. As prices change proportionally, this budget constraint shifts, impacting the quantity of goods the consumer can afford without affecting the preference for one good over the other.

• The budget constraint illustrates the limit of consumption possibilities for consumers given their income and prevailing prices.
• For perfect substitutes, when prices change proportionally, the sloping line of the budget constraint remains parallel, indicating no preference switch but purely an income effect change.