CFA® Program Curriculum, Volume 2, page 79 In Figure 3, we have drawn a consumer’s budget constraint along with some of her indifference curves. The optimal (most preferred) consumption bundle for this consumer is at the point where indifference curve /j is tangent to the budget line. While there are affordable bundles along /Q, all bundles along /Q are less preferred than those along Iy Bundles along I2 are preferred to those along Iy but none are affordable. In short, we represent a consumer’s equilibrium bundle of goods, the most preferred affordable combination of Good X and Good Y, as the point where the highest attainable indifference curve is just tangent to the budget line.
Figure 3: A Consumer’s Equilibrium Bundle of Goods
Units of Good Y
LOS 14.e: Compare substitution and income effects. * 1
CFA® Program Curriculum, Volume 2, page 84 When the price of Good X decreases, there is a substitution effect that shifts
consumption towards more of Good X. Because the total expenditure on the consumer’s original bundle of goods falls when the price of Good X falls, there is also an income effect. The income effect can be toward more or less consumption of Good X. This is the key point here: the substitution effect always acts to increase the consumption of a good that has fallen in price, while the income effect can either increase or decrease consumption of a good that has fallen in price.
Based on this analysis, we can describe three possible outcomes of a decrease in the price of Good X:
1. The substitution effect is positive, and the income effect is also positive—
consumption of Good X will increase.
2. The substitution effect is positive, and the income effect is negative but smaller than the substitution effect—consumption of Good X will increase.
3. The substitution effect is positive, and the income effect is negative and larger than the substitution effect—consumption of Good X will decrease.
Graphical representations of these three cases are illustrated in Figure 4. The initial budget line is B0, and the new budget line after a decrease in the price of Good X is B2. The substitution effect on the consumer’s preferred consumption bundle is shown by constructing a (theoretical) budget line that is parallel to the new budget line B2 and is also tangent to the original indifference curve /Q. We are essentially finding the consumption bundle that the consumer would prefer at the new relative prices if his utility were unchanged (i.e., the new bundle must be on /Q). The substitution effect of the decrease in the price of Good X is always positive and is shown as the increase in the quantity of X from Qq to .
The income effect is shown as the change in consumption from 7^ to the new tangency point T2 (most preferred bundle) of indifference curve I2 and the new budget line B2, and the change in quantity from Q§ to Qr
In Panel (a), both the income and substitution effects increase consumption of Good X. In Panel (b), the income effect is negative but smaller in magnitude than the
substitution effect, so the total effect of the price reduction on the consumption of Good X is still positive, an increase from Qq to Qr In Panel (c), the negative income effect is larger than the substitution effect, and the total effect of the reduction in the price of Good X is a decrease in the quantity of X from Qq to Qj. This represents a case where the law of demand is violated, and a decrease in the price of Good X actually reduces the quantity of Good X demanded.
Study Session 4
Figure 4: Income and Substitution Effects Units of (a) Positive Income Effect
Good Y
Units of Good X
substitution effect income effect
Units of (b) Negative Income Effect, Smaller Than Substitution Effect Good Y
I---► substitution effect
<—I income effect
Units of (c) Negative Income Effect, Larger Than Substitution Effect Good Y
I---► substitution effect
<--- 1 income effect
LOS l4.f: Distinguish between normal goods and inferior goods, and explain Giffen goods and Veblen goods in this context.
CFA® Program Curriculum, Volume 2, page 87 A normal good is one for which the income effect is positive, as in Panel (a) of Figure 4. An inferior good is one for which the income effect is negative, as in panels (b) and (c) of Figure 4. A Giffen good is an inferior good for which the negative income effect outweighs the positive substitution effect when price falls, as in Panel (c). A Giffen good is theoretical and would have an upward-sloping demand curve. At lower prices, a smaller quantity would be demanded as a result of the dominance of the income effect over the substitution effect.
A Veblen good is one for which a higher price makes the good more desirable. The idea is that the consumer gets utility from being seen to consume a good that has high status (think Gucci bag), and that a higher price for the good conveys more status and increases its utility. Such a good could conceivably have a positively sloped demand curve for some individuals over some range of prices. If such a good exists, there must be a limit to this process, or the price would rise without limit.
There are two important distinctions between Giffen goods and Veblen goods. First, Giffen goods are inferior goods (negative income effect), while Veblen goods certainly are not. Second, the existence of Giffen goods is theoretically supported by our rules of consumer choice, while the existence of Veblen goods is not.
Study Session 4 K ey C oncepts
LOS 14.a
A consumer who selects his most preferred bundle (combination) of goods for consumption from all affordable bundles is said to be maximizing his utility. A given bundle of goods is preferred to all other bundles of goods that provide less utility.
LOS I4.b
An indifference curve shows all combinations of two goods among which a specific consumer is indifferent (i.e., all combinations of the two goods along an indifference curve are equally preferred).
An opportunity set is all the combinations of goods that are affordable to a specific consumer.
LOS I4.c
A budget constraint for two goods is all combinations of goods that will, given the prices of the two goods, just exhaust a consumer’s income.
Units of Good Y
Units of Good X
LOS I4.d
Given a budget constraint and a specific consumer’s indifference curves, the consumer’s most preferred combination of two goods along the budget constraint is represented by the point where one of the consumer’s indifference curves is just tangent to the budget constraint.
Units of Good Y
Less preferred affordable bundles