Contact Author Income and Substitution Effects of a Price Change A change in the price of a commodity alters the quantity demanded by consumer. This is known as price effect. However, this price effect comprises of two effects, namely substitution effect and income effect. Substitution Effect Let us consider a two-commodity model for simplicity. When the price of one commodity falls, the consumer substitutes the cheaper commodity for the costlier commodity.
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Contact Author Income and Substitution Effects of a Price Change A change in the price of a commodity alters the quantity demanded by consumer. This is known as price effect. However, this price effect comprises of two effects, namely substitution effect and income effect. Substitution Effect Let us consider a two-commodity model for simplicity. When the price of one commodity falls, the consumer substitutes the cheaper commodity for the costlier commodity. This is known as substitution effect.
Again, let us consider a two-commodity model for simplicity. Assume that the price of one commodity falls. Due to an increase in the real income, the consumer is now able to purchase more quantity of commodities. This is known as income effect. Hence, according to our example, the decline in the price level leads to an increasing consumption.
This occurs because of the price effect, which comprises income effect and substitution effect. Now, can you tell how much increase in consumption is due to income effect and how much increase in consumption is due to substitution effect? To answer this question, we need to separate the income effect and substitution effect. How to separate the income effect and substitution effect? Let us look at figure 1. Figure 1 shows that price effect change in Px , which comprises substitution effect and income effect, leads to a change in quantity demanded change in Qx.
Figure 1 The splitting of the price effect into the substitution and income effects can be done by holding the real income constant. When you hold the real income constant, you will be able to measure the change in quantity caused due to substitution effect.
Hence, the remaining change in quantity represents the change due to income effect. To keep the real income constant, there are mainly two methods suggested in economic literature: The Hicksian Method The Hicksian Method Let us look at J.
In figure 2, the initial equilibrium of the consumer is E1, where indifference curve IC1 is tangent to the budget line AB1. Assume that the price of commodity X decreases income and the price of other commodity remain constant.
This result in the new budget line is AB2. Hence, the consumer moves to the new equilibrium point E3, where new budget line AB2 is tangent to IC2. Thus, there is an increase in the quantity demanded of commodity X from X1 to X2. An increase in the quantity demanded of commodity X is caused by both income effect and substitution effect.
Now we need to separate these two effects. In order to do so, we need to keep the real income constant i. This means that an increase in quantity demanded of commodity X from X1 to X3 is purely because of the substitution effect. We get the income effect by subtracting substitution effect X1X3 from the total price effect X1X2. Figure 3 illustrates the Slutskian version of calculating income effect and substitution effect.
In figure 3, AB1 is the initial budget line. Suppose the price of commodity X falls price effect takes place and other things remain the same. Now the consumer shifts to another equilibrium point E2, where indifference curve IC3 is tangent to the new budget line AB2.
This is the total price effect caused by the decline in price of commodity X. Now the task before us is to isolate the substitution effect.
What we are doing here is that we make the consumer to purchase his original consumption bundle i. In figure 3, this is illustrated by drawing a new budget line A4B4, which passes through original equilibrium point E1 but is parallel to AB2. Now the only possibility of price effect is the substitution effect. In Slutsky version, the substitution effect leads the consumer to a higher indifference curve.
The Slutsky Substitution Effect – Explained
There is another important version of substitution effect put forward by E. The treatment of the substitution effect in these two versions has a significant difference. His purchasing power changes by the amount equal to the change in the price multiplied by the number of units of the good which the individual used to buy at the old price. That is, the income is changed by the difference between the cost of the amount of good X purchased at the old price and the cost of purchasing the same quantity if X at the new price. Income is then said to be changed by the cost difference.
The Hicksian Method and The Slutskian Method
Separation of Substitution and Income Effects from the Price Effect
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