Income & Substitution effects.
A fall in the price of commodity has two effects:
- The consumer enjoys an increase in real purchasing power, because they can buy the same amount of the good for less money and thus have money left for additional expenditures (purchases).
- They will consume more of the good that has become cheaper and less of the goods that are now relatively more expensive.
These two effects occur simultaneously but the distinction can be drawn between them for analytical analysis.
a). Substitution effect.
This effect measures the change in the purchase of a good that results from the change in its relative price alone. In this case the utility (satisfaction) remains constant but the price changes.
b). Income effect
It is a change in the consumption of a good resulting from the change in the purchasing power of money that occurs as a result of a price change. In this case the price remains constant but utility changes.
Income and substitution.
The consumer is initially at A on the budget line RS, thereby obtaining level of utility associated with the curve of indifference U1. When the price of food falls the budget line rotates outwards to line RT. The consumer now chooses to consume market basket B on the indifference curve U2.and the consumption increases (consumption of food) by F1F2 (i.e. from 0F1 to 0F2) While the consumption of clothing declines as represented by line segment C1C2 (i.e. from 0C1 to 0C2)
The substitution effect
can be measured by drawing a budget line parallel to the new budget line RT (reflecting the lower relative price of food) but that is just tangent to the original indifference curve. Thus holding the level of utility constant. Given the budget line, the consumer chooses market basket C and consumes 0E units of goods. Therefore line segment F1E represents the substitution effect (move from A to C)
The income effect.
EF2 (associated with the move from C to B) keeps relative prices constant but increases real income (satisfaction) => Food is a normal good because the income effect EF2 is positive.
Income and substitution effects.
Substitution and income effects for a normal goods work in the same direction (positive)
For inferior goods the income and substitution effects move in opposite direction
The income and substitution effects for Inferior good
Consumer is initially at equilibrium at market basket A on budget line RS and he is consuming 0F1 units of food thereby obtaining the utility level associated with indifference curve U1.
A decrease in the price of food shifts the budget line to line RT, where the consumer chooses market basket B on indifference curve U2
The substitution effect could be measured by drawing a new line parallel to budget line RT, that is tangent to indifference curve U1. Given that budget line the consumer chooses market basket C and now is consuming 0F2 units of Food therefore the substitution effect is represented by line segment F1F2 (the move from A to C) on indifference curve U1.
The income effect occurs when the dotted budget line (DG) passing through shifts outward to budget line RT. The consumer chooses market basket B instead of market basket Con indifference curve U2 [increase in income] leading to a decline in food consumption. (The move from OF2 to OE).
The income effect is represented by EF2 that is move from B to C. In this case food is inferior Ю income effect is negative because when income rises consumption falls.
However the substitution is larger than income effect
So decrease in price on food initially leads to an increase in Quantity of food demanded.
- Production possibility curve
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- Two special cases of market equilibrium
- Consumer behavior
- Budget constraint
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- Income and substitution effects
- Elasticity of demand
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