What are Income and Substitution Effects?
When the price of a good changes, there will be two effects on the consumer.
Firstly, there will be a price effect where the price of the goods have changes relative to the other product.
Secondly, there will be an income effect where the change in the price of the goods will change the real income of the consumer.
When the price of a good changes, there will be two effects on the consumer.
Firstly, there will be a price effect where the price of the goods have changes relative to the other product.
Secondly, there will be an income effect where the change in the price of the goods will change the real income of the consumer.
Substitution Effect
It's the effect of relative price change, without changes in real income. It is the bundle that would make the consumer just as happy as before the price change. In lay man term, you can think of it like, when the price of goods A has gone up, how much would you substitute it with another goods?
To find this point we consider a budget line characterized by the new prices but with a level of income such that it is tangent to the initial indifference curve.
This point is characterized by two things. (1) It is on the same indifference curve as the original consumption bundle; AND (2) it is the point where a budget line that is parallel to the new budget line is just tangent to initial indifference curve. This "intermediate" budget line is attempting to hold real income fixed so we can isolate the substitution effect.
Income effect
It's the effect of relative price change, without changes in real income. It is the bundle that would make the consumer just as happy as before the price change. In lay man term, you can think of it like, when the price of goods A has gone up, how much would you substitute it with another goods?
To find this point we consider a budget line characterized by the new prices but with a level of income such that it is tangent to the initial indifference curve.
This point is characterized by two things. (1) It is on the same indifference curve as the original consumption bundle; AND (2) it is the point where a budget line that is parallel to the new budget line is just tangent to initial indifference curve. This "intermediate" budget line is attempting to hold real income fixed so we can isolate the substitution effect.
Income effect
It's the effect of the change in real income. For example, when the price goes up the
consumer is not able to buy as many bundles that she could purchase before. This means that in real terms
she has become worse off. As such, an increase in the price of goods X would have decreased the real income of the consumer.
Income effect helps to determine if the good is normal or inferior:
1. Normal goods are goods whose demand increases when income goes up.
2. Inferior goods are goods whose demand decreases when income goes down.
Total effect and law of demand
Unlike the Substitution Effect, the Income Effect can be both positive and negative depending on whether the product is a normal or inferior good. By the way we constructed them, the Substitution Effect plus the Income Effect equals the total effect of the price change.
For normal goods, substitution and income effect usually goes in the same direction. For inferior goods, the effects move in opposite directions with substitution effect taking precedent over income effect. These made the demand curve downward sloping.
Giffen goods
However, Giffen goods are a type of inferior goods whose demand increases as price increases, thus violating the law of demand as the substitution effect is smaller than income effect. This implies that giffen goods have upward sloping demand curve.
Referring to the graph below:
A to C is the Substitution effect
C to B is the Income effetc
Having issues understanding the concepts?
SMS 97587925 or sign up for intro to Econs lesson here
For more information, visit www.uoltuition.com
Income effect helps to determine if the good is normal or inferior:
1. Normal goods are goods whose demand increases when income goes up.
2. Inferior goods are goods whose demand decreases when income goes down.
Total effect and law of demand
Unlike the Substitution Effect, the Income Effect can be both positive and negative depending on whether the product is a normal or inferior good. By the way we constructed them, the Substitution Effect plus the Income Effect equals the total effect of the price change.
For normal goods, substitution and income effect usually goes in the same direction. For inferior goods, the effects move in opposite directions with substitution effect taking precedent over income effect. These made the demand curve downward sloping.
Giffen goods
However, Giffen goods are a type of inferior goods whose demand increases as price increases, thus violating the law of demand as the substitution effect is smaller than income effect. This implies that giffen goods have upward sloping demand curve.
Referring to the graph below:
A to C is the Substitution effect
C to B is the Income effetc
Having issues understanding the concepts?
SMS 97587925 or sign up for intro to Econs lesson here
For more information, visit www.uoltuition.com
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