6 Income and substitution effects of a price change: Slutski and Hicks approaches

Income& substitution effects.

Price of some good decreased. Due to that we become better off. As we become better off we can consume more, including the good, price of which decreased (the budget line shifts to the right). That is the income effect.

Price of a good decreases & this good becomes relatively cheaper. People try to buy more of the good with lower price & less of the good with higher price. That is the substitution effect.

Total effect (change in consumption)

B_1a || B₁ & tangent to U₂ (point G)

1) Common points H & G belong to || budget constraints

The change in consumption gives a pure income effect (X3 – X2)

2) Points G & F belong to the same indifference curve U₂. So, total utility at these points is the same => if a consumer changes his pattern of consumption, it is not because he becomes worse or better off, but because of substitution effect (X2 – X1) – determined by the change of the price ratio. A normal good is a good, the demand for which grows as income grows. For a normal good both effects are negative (when P increases, and quantity demanded decreases).

An inferior good is a good, the demand for which decreases as income grows. For an inferior good effects work in the opposite directions (substitution effect is negative, income effect is positive). Usually the substitution effect is greater than income effect => total effect is negative.

A giffen good is a very specific inferior good. For a giffen good income effect is greater (positive), so the total effect is positive (demand curve goes up).

Hicks and Slutsky effect

Hicks & Slutsky analyzed substitution effect.

IN COMMON: if we take normal goods then we see that substitution & total effect operates in the same direction; total effect will be the sum of substitution & income effects.

DIFFERENCE:

For Income effect – no differences.

For Substitution effect:

Hicks assumed that utility is kept constant, Slutsky – that purchasing power is kept constant (they both speak about real income). No difference for income effect.

I. Let us draw a budget constraint parallel to the final c || b:

x & y belong to the same utility curve => substitution effect

y & z belong to the || budget constraints, they show different levels of income and the same price ratio (the slope of curve is the same) => no substitution effect, but pure income effect

If combine IE & SE we get Total Effect. If P_x1, Q => both effects are negative => TE is negative (inverse relations between price & quantity demanded).

Change in Px₁ also influences the demand for x₂ – cross-price effect. We can distinguish between substitution cross-price, income cross-price & total cross-price effects.

II. Slutsky proposed to turn the original curve round point x until it becomes parallel to the final curve.

Change in consumption of 1^st good by change in income – income effect

x & y – substitution effect

7 Production function & scale effects

Fixed factors of production – inputs cannot be increased in supply within a given time period.

Variable factors of production - inputs can be increased in supply within a given time period.

Production function – mathematical relationship between the output of a good and the inputs used to produce it. It shows how output will be affected by changes in quantity of one or more inputs. Production function is the function of labour, capital, land & entrepreneurial ability.

(1) Production in the shot-run

In the short-run at least one factor is fixed and new firms cannot enter or exit the industry.

Production in the shot-run is subject to the law of diminishing marginal returns, which states that when one or more factors are held fixed there will come a point beyond which the extra output of additional units of the variable factor will ever diminish.

Ex: consider a farm, land = const, the number of workers (labour) increases, there is not enough land to fully occupy all the new additional workers, thus the law of diminishing marginal productivity will come into effect)

TP – total product, MP – marginal product, AP – average product

AP = TP/Q of the factor

MP = ΔTP/ΔQ of the factor

- point a is a point of inflection, after which the TP curve changes the rate of growth;

- at this point MP is maximized;

- at point b AP is maximized and equals to the MP;

- at point c TP of is maximized, further increasing quantity of the variable factor will lead to decrease in output (ex. of the farm: if at point c n workers are hired, (n+1) workers will produce less than n workers)

(2) Production in the long-run

In the long-run (LR) all factors are variable and new firms can enter the industry. In the LR the firm has to make decisions about the scale, the location of operations and combination of factors.

Scale of Production (‘to scale’ means all inputs increase by the same proportion)

Constant returns on scale – a given % increase in inputs will lead to the same % increase in outputs.

Increasing returns on scale – a given % increase in inputs will lead to a larger % increase in outputs.

Decreasing returns on scale – a given % increase in inputs will lead to a smaller % increase in outputs.

The firm experiences economies of scale when increasing the scale of production leads to lower cost per unit of output. As the firm produces more it will need smaller amounts of factors for one unit of output. Reasons for economies of scale may be the following:

- specialization & division of labour on larger scale (ex. on large plants workers are more specialized => more efficient)

- greater efficiency of large machines

- plant economies on scale arise because of the large size of the factory

- overhead costs (costs of general running of a firm) are spread when the firm’s output is greater

- financial economies (ex. large firms may obtain financing cheaper than the small ones)

- economies of scope, when increasing the range of products produced by the firm reduces the cost of producing each one

When a firm gets beyond a certain size, costs per unit of output may start to increase. Diseconomies of scale occur. The reasons may be the following:

- as firm becomes larger management problems of co-ordination and involvement may occur

- workers get discouraged if their jobs are boring and repetitive due to high level of specialization

- production-line processes and complex interdependencies of mass production may lead to great disruption if hold-ups occur.

*If inputs increase slower than output, there is a positive scale effect;

*If inputs increase faster than output=>negative scale effect;

*If inputs and output grow at the same rate=>neutral scale effect, or constant returns to scale.

External economies of scale occur where a firm’s costs per unit of output decrease as the size of the whole industry grows (the firm benefits from the whole industry being large). The benefits are connected with industry infrastructure development: the network of supply agents, training facilities, specialized financial services, etc.

E xternal diseconomies of scale represent the opposite situation caused by e.g. scarcity of raw materials and skilled labour