Hicksian Demand

Published Apr 29, 2024

Definition of Hicksian Demand

Hicksian demand, also known as compensated demand, refers to the changes in the consumption of goods when prices change, holding utility constant. This concept, named after the British economist Sir John Hicks, isolates the substitution effect from the income effect of a price change. In other words, it shows how consumers would adjust their consumption of goods if their income was adjusted to keep their level of utility unchanged in the face of changing prices.

Example

Consider a consumer who enjoys two goods: books and movies. Initially, the price of books rises, leading the consumer to substitute movies for books because they have become relatively cheaper. However, the price increase also effectively reduces the consumer’s real income, potentially causing them to buy fewer of both goods if they are normal goods. To find the Hicksian demand, we adjust the consumer’s income so that they can still afford their initial bundle of goods at the new prices, thereby holding their utility constant. The change in consumption patterns now reflects only the substitution effect, i.e., the movement along the indifference curve to a point where the consumer buys fewer books (due to the higher price) and more movies, without the income effect complicating the analysis.

Why Hicksian Demand Matters

Hicksian demand curves are crucial for understanding consumer behavior beyond the basic law of demand. By focusing on the substitution effect, economists can determine how changes in relative prices influence consumption choices, independent of income changes. This is particularly useful in welfare economics and in estimating the burden of taxation or the benefits of subsidies on consumers. Hicksian demand also facilitates the computation of compensating and equivalent variations, which are measures of how much compensation is needed to offset a price increase or how much a consumer would pay to avoid a price increase, keeping utility constant.

Frequently Asked Questions (FAQ)

How does Hicksian demand differ from Marshallian demand?

Marshallian (or ordinary) demand accounts for both the substitution effect and the income effect of a price change on consumption, reflecting how consumers adjust their purchasing habits with changes in price given their initial income level. Hicksian demand, on the other hand, isolates the substitution effect by adjusting the consumer’s income to hold their utility constant after a price change. This distinction is critical for understanding how consumers would react to price changes if they were compensated for the loss in purchasing power.

What role does Hicksian demand play in welfare economics?

In welfare economics, Hicksian demand is used to assess how changes in prices due to taxes, subsidies, or other market interventions affect consumer welfare. By measuring how much a consumer must be compensated to maintain their level of satisfaction (utility) before and after the change, policymakers can better understand the welfare implications of their decisions, ensuring that the benefits of their actions outweigh the costs to society.

Can Hicksian demand curves intersect?

Hicksian demand curves do not typically intersect. This is because, for a given utility level, there is a unique combination of goods that a consumer will choose at different price ratios, holding their utility constant. The non-intersection property of Hicksian demand curves helps maintain consistency in consumer choice theory, ensuring that consumers’ preferences are transitive and well-behaved, which is a foundational assumption in microeconomics.

How is Hicksian demand used in estimating the effects of taxation?

Economists use Hicksian demand to estimate the deadweight loss and the distributional effects of taxation. By comparing the compensated (Hicksian) and uncompensated (Marshallian) demand curves before and after the imposition of a tax, economists can determine the pure substitution effect of the tax (how much of the good consumers would still buy if they were compensated for the tax) and the income effect (how the tax reduces overall purchasing power). This separation is important for designing efficient tax policies that minimize welfare losses while achieving desired revenue and redistribution goals.

Is there a way to visually represent Hicksian demand?

Yes, Hicksian demand can be visually represented on a graph with goods on the x and y axes and an indifference curve illustrating a level of constant utility. A price change shifts the budget line but, to analyze the Hicksian demand, the consumer’s income is conceptually adjusted to touch the original indifference curve at a new point, highlighting the substitution effect. This graphical representation helps illustrate the theoretical concept of compensated demand and the distinction between the income and substitution effects in response to price changes.