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Lesson 5: Changes in Equilibrium (Part 2) Substitution Effect

The document discusses the substitution effect in economics. It explains that a substitution effect occurs when a rational consumer substitutes a good that has become relatively cheaper for other goods, even if their income remains constant. This movement along the indifference curve does not make the consumer better off. The document provides two examples showing the substitution effect graphically when one price changes while income and other prices remain constant. It also explains how to isolate the substitution effect by moving the new budget line parallel to neutralize the income effect.

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Wassila Elaheebux
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27 views

Lesson 5: Changes in Equilibrium (Part 2) Substitution Effect

The document discusses the substitution effect in economics. It explains that a substitution effect occurs when a rational consumer substitutes a good that has become relatively cheaper for other goods, even if their income remains constant. This movement along the indifference curve does not make the consumer better off. The document provides two examples showing the substitution effect graphically when one price changes while income and other prices remain constant. It also explains how to isolate the substitution effect by moving the new budget line parallel to neutralize the income effect.

Uploaded by

Wassila Elaheebux
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Lesson 5: Changes in equilibrium (part 2)

Substitution effect

A substitution effect means that a rational consumer will substitute in favour of a product which
has now become relatively cheaper.

The consumer is not better off from a substitution effect- movement along the same indifference
curve.

Example 1:

 Equilibrium Point Q
 Income constant
 Px and Py rise. Show substitution effect.

Substitution effect may also take place if income is constant; Py constant and Px falls. This
implies that good x has become relatively cheaper. Therefore, the consumer will substitute unit
x without being better off.

Example 2:

 Equilibrium Point Q
 Income constant
 Py constant and Px falls. Show substitution effect.
Explanation of the diagram

Original equilibrium point is Q. Following a fall in Px, the budget line rotates to AB1. The
consumer’s real income increase, he will have a tendency to buy more of x and become off.

To show the substitution effect of a fall in price, the real income effect of this fall has to
neutralize. To isolate this effect graphically, we move the new budget line inwards and
parallel until it is tangent to the old indifference curve.

The new slope reflects the new relative prices but the utility is the same as it is originally.

Next lesson 7: Splitting of the price effect

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