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."