Turmoil Beneath the Calm Surface
We but scarcely notice the impact of a change in the price of a given commodity on the price of others. This is normal because these impacts are negligible to the naked eye. Nevertheless, microeconomic theory reminds us that a change in the price of a commodity alters the money weighed diminishing marginal rate of substitution linking the given commodity to one, many, or all others, i.e. when goods decrease or increase in value, they become comparatively more desirable –per unit- than other goods –per unit.Why, then, do we not witness apparent changes?
The answer is that, in the case of a change in the price of a mildly substitutable good, the two effects of the change will counteract.
Few goods are complementary –if you buy a car it will increase, from your standpoint, the utility of gas- or inherently competitive –if you by a car it will decrease, from your standpoint, the utility of a bicycle. Most goods are competitive, or substitutive, by the zero-sum nature of consumer choice –if you buy a car, you will have less money to buy other things, say apples- these are mildly substitutive goods.
Hence, most goods are mildly substitutable goods with which we witness the bewildering counteracting actions of the substitution effect and income effect.
To understand the nature of the substitution effect, one has to grasp the concept of the diminishing rate of substitution, the price rate, and their compound.
The price rate is given by the ratio: price X / price Y.
The diminishing rate of substitution is the diminishing quantity of X that one will be willing to submit in exchange of a unit of Y as one goes on submitting X for Y; the more Y you have, the less X you have, the more X has utility, from your standpoint, comparatively to Y. This, of course, is a corollary of the law of diminishing marginal utility.
If we conflate both the price rate and the diminishing rate of substitution –and hence create a money weighed diminishing rate of substitution- we come to realize that the price of things “relativizes” their utility. For example, of two goods having the “same utility”, the one whose price is decreased will become more desirable, i.e. the consumer will reach maximum utility when he will have submitted enough of the expensive good for the inexpensive and that the utility per item of the expensive good will have decreased enough –because the consumer bought more- to reach the increasing utility of the expensive good –of which the consumer buys less and of which the marginal utility is hence “undiminished”- even though it is divided by a greater price.
We now have an idea of the substitution effect in the case of a decrease in the price of X. As X has a lower price, it will be to the benefit of the consumer to sell Y and buy X until the money weighed diminishing rate of substitution of both X and Y equals again. At that point, the consumer reaches equilibrium and is not better off if he trades any X for any Y or the reverse.
We thus witness a decrease in demand for Y.
We may ask again but now with more precision why, then, do we not witness a change in the price of Y?
Some factors may restrain a change in price. The seller might be very close to his “cost” price or the expense necessary to change the price of his goods might be greater than his additional profit at equilibrium –his equilibrium now, not that of the consumer.
What is more important than hampering effects, is the counteracting action, the opposite action, of the income effect.
The income effect is much more simple than the substitution effect. When the price of X diminishes, the consumer buying a given amount of X allocates less capital to that use and therefore liberates income for other purposes –which can include buying more of X. The demand for all goods –including X- is thus created by this increase in real income.
In the case of mild substitutes, this increase in demand counterbalances the decrease in demand for Y created by the substitution effect. To be sure, the demand for X is even more increased by the income effect because it increases demand for all goods except inferior goods –once you are rich and have demand for a car, you have no more demand for a bicycle.
Consequently, even though more X is sold, the demand for Y being stable, so is its relation to supply and hence its price.
posted by blogger @ 9:13 PM
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