Scribd
Upload
613 views3 pages

Understanding Income and Substitution Effects

A change in the price of a good has two effects: the substitution effect and the income effect. The substitution effect refers to consumers buying more of a good that has become relatively cheaper compared to alternatives. The income effect occurs because higher prices reduce purchasing power, similar to a reduction in income. Together these two effects determine the overall impact of a price change on the quantity demanded of a good. An example is provided to illustrate the substitution and income effects graphically using a budget constraint.

Uploaded by

Matthew Mulley
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOC, PDF, TXT or read online on Scribd
613 views3 pages

Understanding Income and Substitution Effects

A change in the price of a good has two effects: the substitution effect and the income effect. The substitution effect refers to consumers buying more of a good that has become relatively cheaper compared to alternatives. The income effect occurs because higher prices reduce purchasing power, similar to a reduction in income. Together these two effects determine the overall impact of a price change on the quantity demanded of a good. An example is provided to illustrate the substitution and income effects graphically using a budget constraint.

Uploaded by

Matthew Mulley
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOC, PDF, TXT or read online on Scribd

Income and Substitution Effects A change in the price of a good has two effects: Substitution Effect Income Effect

Substitution Effect Relative price of a good changes when price changes Consumers will tend to buy more of the good that has become relatively cheaper, and less of the good that is relatively more expensive or example: food and housing! "ousing gets more expensive # relative price of housing to food goes up # less housing more food $eeps you happy! %he substitution effect is the change in an item&s consumption associated with a change in the price of the item, with the level of utility held constant 'hen the price of an item increases, the substitution effect always leads to an decrease in the (uantity demanded of the good

Income Effect Consumers experience a decrease in real purchasing power when the price of one good rises "igher prices reduces opportunity set! )i$e reducing income! %he income effect is the change in an item&s consumption brought about by the decrease in purchasing power, with the price of the item held constant 'hen a person&s income decreases, the (uantity demanded for the product may increase or decrease

Example: Increase in price of trac$s rotates budget constraint from L1 to L2! Substitution effect: Changes relative prices, $eeps utility constant *e+ to e, Income effect: .eeps relative prices constant, changes income! *e, to e/ %otal price effect 0 +/ Composed of: Substitution effect 0 1 Income effect02

Giffen Good (Inferior Good) 'hen the price of movie tic$ets decreases the budget constraint rotates out, allowing the consumer to increase her utility! 3evertheless, the total effect is negative! Even though the substitution effect is positive, the income effect is larger and negative *since this is an inferior good-!

You might also like