Economists, I told my class, are the most empathetic and tolerant of people. Empathetic, as they learnt from game theory, because they strive to see the world through the eyes of others. Tolerant, because they never question anyone’s preferences. If I had the talent I’d have broken into song with a version of `Why Can’t a Woman be More Like a Man’ :
Psychologists are irrational, that’s all there is to that!
Their heads are full of cotton, hay, and rags!
They’re nothing but exasperating, irritating,
vacillating, calculating, agitating,
Maddening and infuriating lags!
Why can’t a psychologist be more like an economist?
Back to earth with preference orderings. Avoided the word rational to describe the restrictions placed on preference orderings, used `consistency’ instead. More neutral and conveys the idea that inconsistency makes prediction hard rather that suggesting a Wooster like IQ. Emphasized that utility functions were simply a succinct representation of consistent preferences and had no meaning beyond that.
In a bow to tradition went over the equi-marginal principle, a holdover from the days when economics students were ignorant of multivariable calculus. Won’t do that again. Should be banished from the textbooks.
Now for some meat: the income and substitution (I&S) effect. Had been warned this was tricky. `No shirt Sherlock,’ my students might say. One has to be careful about the set up.
Suppose price vector and income . Before I actually purchase anything, I contemplate what I might purchase to maximize my utility. Call that .
Again, before I purchase , the price of good 1 rises. Again, I contemplate what I might consume. Call it . The textbook discussion of the income and substitution effect is about the difference between and .
As described, the agent has not purchased or . Why this petty foggery? Suppose I actually purchase $x$ before the price increase. If the price of good 1 goes up, I can resell it. This is both a change in price and income, something not covered by the I&S effect.
The issue is resale of good 1. Thus, an example of an I&S effect using housing should distinguish between owning vs. renting. To be safe one might want to stick to consumables. To observe the income effect, we would need a consumable that sucks up a `largish’ fraction of income. A possibility is low income consumer who spends a large fraction on food.