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Income Effect, Substitution Effect and Price Effect!: Advertisements

1) The income effect refers to how a consumer's purchases change when their income changes, holding prices constant. If income increases, the budget line shifts outward allowing purchase of more goods. 2) A substitution effect occurs when the price of a good changes, causing a consumer to substitute toward the relatively cheaper good while maintaining the same purchasing power. 3) The price effect shows how the quantity demanded of a good changes as its price changes, given income, tastes, and the price of the other good. The budget line shifts in or out as the good's price decreases or increases.

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87 views9 pages

Income Effect, Substitution Effect and Price Effect!: Advertisements

1) The income effect refers to how a consumer's purchases change when their income changes, holding prices constant. If income increases, the budget line shifts outward allowing purchase of more goods. 2) A substitution effect occurs when the price of a good changes, causing a consumer to substitute toward the relatively cheaper good while maintaining the same purchasing power. 3) The price effect shows how the quantity demanded of a good changes as its price changes, given income, tastes, and the price of the other good. The budget line shifts in or out as the good's price decreases or increases.

Uploaded by

nithin adithya
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Income Effect, Substitution Effect and 

Price Effect!
In the above analysis of the consumer’s equilibrium it was assumed
that the income of the consumer remains constant, given the prices of
the goods X and Y. Given the tastes and preferences of the consumer
and the prices of the two goods, if the income of the consumer
changes, the effect it will have on his purchases is known as the
income Effect.

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If the income of the consumer increases his budget line will shift
upward to the right, parallel to the original budget line. On the
contrary, a fall in his income will shift the budget line inward to the
left. The budget lines are parallel to each other because relative prices
remain unchanged.
In Figure 12.14 when the budget line is PQ, the equilibrium point is R
where it touches the indifference curve I1. If now the income of the
consumer increases, PQ will move to the right as the budget line P 1, I1,
and the new equilibrium point is S where it touches the indifference
curve I2. As income increases further, PQ becomes the budget line with
T as its equilibrium point.
The locus of these equilibrium points R, S and T traces out a curve
which is called the income-consumption curve (ICC). The ICC curve
shows the income effect of changes in consumer’s income on the
purchases of the two goods, given their relative prices.

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Normally, when the income of the consumer increases, he purchases


larger quantities of two goods. In Figure 12.14 he buys RA of Y and OA
of X at the equilibrium point R on the budget line PQ. As his income
increases, he buys SB of Y and OB of X at the equilibrium point S on
P1, Q1, budget line and still more of the two goods TC of Y and ОС of X,
on the budget line P2Q2. Usually, the income consumption curve slopes
upwards to the right as shown in Figure 12.14.
But an income-consumption curve can have any shape provided it
does not intersect an indifference curve more than once. We can have
five types of income consumption curves. The first type is explained
above in Figure 12.14 where the ICC curve has a positive slope
throughout its range. Here the income effect is also positive and both
X and Y are normal goods.
The second type of ICC curve may have a positive slope in the
beginning but become and stay horizontal beyond a certain point
when the income of the consumer continues to increase. In Figure
12.15 (A) the ICC curve slopes upwards with the increase in income
upto the equilibrium point R at the budget line P1Q1 on the indifference
cure I2. Beyond this point it becomes horizontal which signifies that
the consumer has reached the saturation point with regard to the
consumption of good Y. He buys the same amount of Y (RA) as before
despite further increases in his income. It often happens in the case of
a necessity (like salt) whose demand remains the same even when the
income of the consumer continues to increase further. Here Y is a
necessity.
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Figure 12.15 (B) shows a vertical income consumption curve when the
consumption of good X reaches the saturation level R on the part of
the consumer. He has no inclination to increase its purchases despite
further increases in his income. He continues to purchase OA of it
even at higher income levels. Thus X is a necessity here.

The last two types of income consumption curves relate to inferior


goods. The demand of inferior goods falls, when the income of the
consumer increases beyond a certain level, and he replaces them by
superior substitutes. He may replace coarse grains by wheat or rice,
and coarse cloth by a fine variety. In Figure 12.15 (C), good Y is inferior
and X is a superior or luxury good.

Upto point R the ICC curve has- a positive slope and beyond that it is
negatively inclined. The consumer’s purchases of Y fall with the
increase in his income. Similarly in Figure 12.15 (D), good X is shown
as inferior and Y is a superior good beyond the equilibrium point R
when the ICC curve turns back upon itself. In both these cases the
income effect is negative beyond point R on the income-consumption
curve ICC.
The different types of income-consumption curves are also shown in
Figure 12.16 where: (1) ICC1 Alternative Method, has a positive slope
and relates to normal goods; (2) IСС2 is horizontal from point A, X is a
normal good while Y is a necessity of which the consumer does not
want to have more than the usual quantity as his income increases
further: (3) IСС3 is vertical from A, К is a normal good here and X is
satiated necessity; (4) ICC4 is negatively inclined downwards, Y
becomes an inferior good form A onwards and X is a superior good;
and (5) ICC5 shows X as an inferior good.
The Substitution Effect:
The substitution effect relates to the change in the quantity demanded
resulting from a change in the price of good due to the substitution of
relatively cheaper good for a dearer one, while keeping the price of the
other good and real income and tastes of the consumer as constant.
Prof. Hicks has explained the substitution effect independent of the
income effect through compensating variation in income. “The
substitution effect is the increase in the quantity bought as the price of
the commodity falls, after adjusting income so as to keep the real
purchasing power of the consumer the same as before. This
adjustment in income is called compensating variations and is shown
graphically by a parallel shift of the new budget line until it become
tangent to the initial indifference curve.”

Thus on the basis of the methods of compensating variation, the


substitution effect measure the effect of change in the relative price of
a good with real income constant. The increase in the real income of
the consumer as a result of fall in the price of, say good X, is so
withdrawn that he is neither better off nor worse off than before.
The substitution effect is explained in Figure 12.17 where the original
budget line is PQ with equilibrium at point R on the indifference curve
I1. At R, the consumer is buying OB of X and BR of Y. Suppose the
price of X falls so that his new budget line is PQ 1. With the fall in the
price of X, the real income of the consumer increases. To make the
compensating variation in income or to keep the consumer’s real
income constant, take away the increase in his income equal to PM of
good Y or Q1N of good X so that his budget line PQ1 shifts to the left as
MN and is parallel to it.

At the same time, MN is tangent to the original indifference curve


l1 but at point H where the consumer buys OD of X and DH of Y. Thus
PM of Y or Q1N of X represents the compensating variation in income,
as shown by the line MN being tangent to the curve I1 at point H. Now
the consumer substitutes X for Y and moves from point R to H or the
horizontal distance from В to D. This movement is called the
substitution effect. The substitution affect is always negative because
when the price of a good falls (or rises), more (or less) of it would be
purchased, the real income of the consumer and price of the other
good remaining constant. In other words, the relation between price
and quantity demanded being inverse, the substitution effect is
negative.
The Price Effect:
The price effect indicates the way the consumer’s purchases of good X
change, when its price changes, A given his income, tastes and
preferences and the price of good Y. This is shown in Figure 12.18.
Suppose the price of X falls. The budget line PQ will extend further out
to the right as PQ1, showing that the consumer will buy more X than
before as X has become cheaper. The budget line PQ2 shows a further
fall in the price of X. Any rise in the price of X will be represented by
the budget line being drawn inward to the left of the original budget
line towards the origin.

If we regard PQ2, as the original budget line, a two time rise in the
price of X will lead to the shifting of the budget line to PQ1, and PQ2.
Each of the budget lines fanning out from P is a tangent to an
indifference curve I1, I2, and I3 at R, S and T respectively. The curve
PCC connecting the locus of these equilibrium points is called the
price- consumption curve. The price-consumption curve indicates the
price effect of a change in the price of X on the consumer’s purchases
of the two goods X and Y, given his income, tastes, preferences and the
price of good Y.

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