CHAPTER II -- Section 7

We're nearing the end of Chapter II of Value and Capital -- after this section, the only remaining material is a technical note connecting the results of this chapter with the topic of consumer's surplus.  In Section 7, Hicks extends his analysis to consider the case of a consumer who comes to the market as both a buyer and a seller of some commodity X.

If we assume the price of X remains fixed, then the previous conclusions of this chapter are unaffected.  The consumer can be assumed to sell at the given price whatever stock of commodity X he brought to the market, then use the proceeds (and whatever other income he had) to purchase a bundle of commodities to maximize his utility.

If the price of X can vary, the situation changes slightly.  The substitution effect works the same as before;  a fall in the price of X will increase the demand for X through consumers substituting X for some of the other purchases they would have made.  The income effect is different, though.  A seller of X is made worse off by a fall in the price of X, so he will decrease his own purchases of X (unless X is for him an inferior good).  Thus, for a seller, income and substitution effects work in opposite directions (except in the unusual case of inferior goods), whereas for buyers the two effects work in the same direction.

Hicks notes that sellers often derive large parts of their income from one particular thing they sell and that in such a case "the income effect is just as powerful as the substitution effect, or is dominant.  We must conclude that a fall in the price of X may either diminish its supply or increase it."  He goes on to argue that this phenomenon is most pronounced in the case of the factors of production.

Thus a fall in wages may sometimes make the wage-earner work less hard, sometimes harder; for, on the one hand, reduced piece-rates make the effort needed for a marginal unit of output seem less worth while, or would do so, if incomes were unchanged; but on the other, his income is reduced, and the urge to work harder in order to make up for the loss in income may counterbalance the first tendency.

Hicks notes that this asymmetry between supply and demand had long been known.  But he regards the explanation of its cause in terms of income and substitution effects "as one of the first-fruits of our new technique."

CHAPTER II -- Section 6

In this section Hicks summarizes the conclusions thus far about the law of demand.  The demand curve (expressing the quantity of a commodity demanded as a function of its price) must always slope downward whenever the commodity is not an inferior good.  Even when the commodity is an inferior good, the demand curve will still slope downward as long as the proportion of income spent on the commodity is small.  And finally, even if neither of the above qualifications apply, the demand curve may still slope downward if substitution effects are large.

Hicks notes that, "Consumers are only likely to spend a large proportion of their incomes on what is for them an inferior good if their standard of living is very low," and he notes that the Giffen case, quoted by Alfred Marshall exactly fits this description.  But cases such as this are clearly rare.

Therefore, Hicks concludes that, "The simple law of demand -- the downward slope of the demand curve -- turns out to be almost infallible in its working.  Exceptions to it are rare and unimportant."

CHAPTER II -- Section 5

In this brief section, Hicks discusses making the transition from analyzing individual demand to analyzing market demand.

He notes that market demand is the sum of individual demands.  Therefore, the change in market demand is the sum of changes in the individual demands.  A change in market demand due to a change in price can be divided into substitution and income effects.  The substitution effect consists of the sum of the individual substitution effects, and the income effect consists of the sum of the individual income effects.  Since all the individuals' substitution effects imply increased consumption of a good whose price falls, the market substitution effect must imply the same.  Individual income effects are not as reliably uniform in direction, therefore the group income effect must be similarly unreliable.  Finally, group income effects will tend to be negligible for any commodity on which the group spends a small proportion of its total income.