[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

tive or negative. Generally, though, as individuals become better off, they typically
reduce their consumption of these goods.
THE IMPORTANCE OF DISTINGUISHING
BETWEEN INCOME AND SUBSTITUTION
EFFECTS
Distinguishing between the income and substitution effects of a change in price is
important for two reasons.
Understanding Responses to Price Changes First, the distinction
improves our understanding of consumption responses to price changes. Thinking
about the substitution effect helps us understand why some demand curves have a
low price elasticity and others a high price elasticity. It also helps us understand
why the price elasticity may well differ at different points along the demand curve.
Recall from Chapter 4 that when an individual is consuming large amounts of
one good, substitutes for it are easy to find, and a small increase in price leads to a
large reduction in the quantity demanded; but as consumption falls, finding good
substitutes becomes increasingly difficult.
Or consider the effect of an increase in the price of one good on the demand for
other goods. There is always an income effect; the income effect, by itself, would lead
to reduced consumption of all commodities. But the substitution effect leads to
increased consumption of substitute commodities. Thus, an increase in the price of Coke
will lead to increased demand for Pepsi at each price; the demand curve for Pepsi
shifts to the right, because the substitution effect outweighs the slight income effect.
Understanding Inefficiencies Associated with Taxes A second reason
to focus on income and substitution effects is to identify some of the inefficiencies
associated with taxation. The purpose of a tax is to raise revenue so that the government
can purchase goods; it represents a transfer of purchasing power from
the household to the government. If the government is to obtain more resources,
individuals have to consume less. Thus, any tax must have an income effect.
But beyond that, taxes often distort economic activity. The distortion caused by
taxation is associated with the substitution effect. Take the window tax discussed in
Chapter 4. Intended to raise revenue, it instead led people to cover up their windows—a
major distortion of the tax. Most of the distortions associated with modern
taxes are somewhat more subtle. Consider a tax on airline tickets or on telephone
calls. Reducing consumption of things that are against society’s interest can be a
legitimate goal of taxation. But the government does not think flying or making telephone
calls is a bad thing. The tax is levied simply to raise revenues. But it results
in fewer air flights and telephone calls anyway—an unintentional consequence. Any
tax leads to some reduction in consumption, through the income effect. But most
taxes also change relative prices; so they have a substitution effect. It is the substitution
effect that gives rise to the distortion. If the substitution effect is small, the
distortion is small; if the substitution effect is large, the distortion is large.
A CLOSER LOOK AT THE DEMAND CURVE ∂ 111