An examination of our discussion so far would reveal that a change in the price ofX will also affect the quantity demanded of the other good (Y). In Figure 3.3, for example, a decrease in the price ofXcauses not only the quantity demanded ofXto increase but the quantity demanded ofYto increase as well. We can explain this
F I G U R E 3 . 6
T he Lum p-Su m Prin c iple Quantity of Y
per week
Y2 Y*
Y1
I
Iⴕ Iⴖ
U3 U2 U1
Quantity of X per week X1 X2 X*
An excise tax on goodXshifts the budget constraints toI0. The individual choosesX1,Y1 and receives utility ofU1.Alump-sum tax that collects the same amount shifts the budget constraint toI00. The individual choosesX2,Y2and receives more utility (U2).
A P P L I C A T I O N 3 . 3 Why Not Just Give the Poor Cash?
Most countries provide a wide variety of programs to help poor people. In the United States, there is a general program for cash assistance to low-income families, but most anti- poverty spending is done through a variety of ‘‘in-kind’’
programs such as Food Stamps, Medicaid, and low-income housing assistance. Such programs have expanded very rapidly during the past 30 years, whereas the cash program has tended to shrink (especially following the 1996 welfare reform initiative).
Inefficiency of In-Kind Programs
The lump-sum principle suggests that these trends may be unfortunate because the in-kind programs do not generate as much welfare for poor people as would the spending of the same funds on a cash program. The argument is illu- strated in Figure 1. The typical low-income person’s budget constraint is given by the lineIprior to any assistance. This yields a utility ofU1. An anti-poverty program that provided,
say, good Xat a highly subsidized price would shift this budget constraint toI0and raise this person’s utility toU2. If the government were instead to spend the same funds on a pure income grant to this person,1his or her budget con- straint would beI00, and this would permit a higher utility to be reached (U3). Hence, the in-kind program is not cost- effective in terms of raising the utility of this low-income person.
There is empirical evidence supporting this conclusion.
Careful studies of spending patterns of poor people suggest that a dollar spent on food subsidy programs is ‘‘worth’’ only about $.90 to the recipients. A dollar in medical care sub- sidies may be worth only about $.70, and housing assistance may be worth less than $.60. Spending on these kinds of in- kind programs therefore may not be an especially effective way of raising the utility of poor people.
Paternalism and Donor Preferences
Why have most countries favored in-kind programs over cash assistance? Undoubtedly, some of this focus stems from paternalism—policy makers in the government may feel that they have a better idea of how poor people should spend their incomes than do poor people themselves. In Figure 1, for example, X purchases are indeed greater under the in-kind program than under the cash grant, though utility is lower. A related possibility is that ‘‘donors’’ (usually taxpayers) have strong preferences for how aid to poor people should be provided. Donors may care more about providing food or medical care to poor people than about increasing their welfare overall. Political support for (see- mingly less effective) cash grants is simply nonexistent.
POLICYCHALLENGE
The apparent preference for in-kind subsidies has led to a vast increase in the amounts spent on such subsidies in many countries. Is it generally good for governments to decide how people collecting subsidies should spend their money?
Or might such subsidies really have little value to those who receive them? Which kinds of subsidies might make sense?
Which kinds might be wasteful in the sense that poor people get little value for the money spent by the government?
FIGURE 1Superiority of an Income Grant
U3 U2
U1 Y per
period
X per period
Iⴕ Iⴖ
I B
A subsidy on goodX(constraintI0) raises utility toU2. For the
same funds, a pure income grant (I00) raises utility toU3. 1Budget constraintsI0andI00represent the same government spend- ing because both permit this person to consume pointB.
result by looking at the substitution and income effects on the demand for Y associated with the decrease in the price ofX.
First, as Figure 3.3 shows, the substitution effect of the lowerXprice caused lessYto be demanded. In moving along the indifference curveU1fromAtoB,X is substituted forYbecause the lower ratio ofPX/PYrequired an adjustment in the MRS. In this figure, the income effect of the decline in the price of good X is strong enough to reverse this result. BecauseYis a normal good and real income has increased, moreYis demanded: The individual moves fromBtoC. HereY**
exceeds Y*, and the total effect of the price change is to increase the demand forY.
A slightly different set of indifference curves (that is, different preferences) could have shown different results. Figure 3.7 shows a relatively flat set of indif- ference curves where the substitution effect from a decline in the price ofXis very large. In moving fromAtoB, a large amount ofXis substituted forY. The income effect onYis not strong enough to reverse this large substitution effect. In this case,
F I G U R E 3 . 7
Ef f e c t o n t h e Dem a nd f o r G o odYof a Decre ase i n t he P r i ce of Go o dX
Quantity of Y per week
Y**
Y*
U2 U1
Quantity of X per week New budget constraint Old budget constraint
X* X**
B A
C
0
In contrast to Figure 3.3, the quantity demanded ofYnow declines (fromY* toY**) in response to a decrease in the price ofX. The relatively flat indifference curves cause the substitution effect to be very large. Moving fromAtoBmeans giving up a substantial quantity ofYfor additionalX. This effect more than outweighs the positive income effect (fromBtoC), and the quantity demanded ofYdeclines. So, purchases ofYmay either rise or fall when the price ofXfalls.
the quantity ofYfinally chosen (Y**) is smaller than the original amount. The effect of a decline in the price of one good on the quantity demanded of some other good is ambiguous; it all depends on what the person’s preferences, as reflected by his or her indifference curve map, look like. We have to examine carefully income and substitution effects that (at least in the case of only two goods) work in opposite directions.
Substitutes and Complements
Economists use the terms substitutes and complements to describe the way people look at the relationships between goods. Complements are goods that go together in the sense that people will increase their use of both goods simulta- neously. Examples of complements might be coffee and cream, fish and chips, peanut butter and jelly, or gasoline and automobiles. Substitutes, on the other hand, are goods that can replace one another. Tea and coffee, Hondas and Pontiacs, or owned versus rented housing are some goods that are substitutes for each other.
Whether two goods are substitutes or complements of each other is primarily a question of the shape of people’s indifference curves. The market behavior of individuals in their purchases of goods can help economists to discover these relationships. Two goods arecomplementsif an increase in the price of one causes a decrease in the quantity consumed of the other. For example, an increase in the price of coffee might cause not only the quantity demanded of coffee to decline but also the demand for cream to decrease because of the complementary relationship between cream and coffee. Similarly, coffee and tea are substitutes because an increase in the price of coffee might cause the quantity demanded of tea to increase as tea replaces coffee in use.
How the demand for one good relates to the price increase of another good is determined by both income and substitution effects. It is only the combined gross result of these two effects that we can observe. Including both income and substitu- tion effects of price changes in our definitions of substitutes and complements can sometimes lead to problems. For example, it is theoretically possible forXto be a complement forYand at the same time forYto be a substitute forX. This perplexing state of affairs has led some economists to favor a defini- tion of substitutes and complements that looks only at the direction of substitution effects.3We do not make that distinction in this book, however.
Complements Two goods such that when the price of one increases, the quantity demanded of the other falls.
Substitutes
Two goods such that if the price of one increases, the quantity demanded of the other rises.
M i c r o Q u i z 3 . 3
Changes in the price of another good create both income and substitution effects in a per- son’s demand for, say, coffee. Describe those effects in the following cases and state whether they work in the same direction or in opposite directions in their total impact on coffee purchases.
1. A decrease in the price of tea 2. A decrease in the price of cream
3For a slightly more extended treatment for this subject, see Walter Nicholson and Christopher Snyder,Micro- economic Theory: Basic Principles and Extensions, 10th ed. (Mason, OH: South-Westen/Thomson Learning, 2008), 184–188. For a complete treatment, see J. R. Hicks,Value and Capital(London: Cambridge University Press, 1939), Chapter 3 and the mathematical appendix.