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Price Change : Income

and Substitution Effect


LBSIM
Dr. Rashmi Ahuja
Impact of Price Change..

• Economists often separate the impact of a


price change into two components: –
– the substitution effect;
– and the income effect.
• The substitution effect involves the
substitution of good x1 for good x2 or vice-
versa due to a change in relative prices of the
two goods.
• The income effect results from an increase or
decrease in the consumer’s real income or
purchasing power as a result of a price
change.
Price effect = Income Effect + Substitution Effect
Two methods
Hicksian Method

Slutsky Method

4
Changes in Goods Price
Hicksian Method
Quantity of y

The consumer is maximizing


utility at point A on indifference curve IC1.

IC1

Quantity of x
X1
5
If the price of good x falls, the budget line
pivots out from Point P. Now, the consumer
Quantity of y will maximize utility at point B on
P
indifference curve IC2.
Total Price effect is from X1 to X2.

A
IC2

IC1

X1 X2 Quantity of x
Total increase in x
6
• To isolate the substitution effect we ask….
“what would the consumer optimal bundle be
if consumer faced the new lower price for X
but experienced no change in real income?”

• This amounts to returning the to the original


indifference curve.
Quantity of y
We draw a line parallel to the new budget line tangent to
the old indifference curve . Now, the consumer optimum
point is C.
The substitution effect is the movement
from point A to point C. i.e. increase in qty of X
from point A to C because it capture the
response to change in relative prices.
A C

IC1

Quantity of x

Substitution effect

8
Quantity of Y The income effect occurs because the individual’s “real”
income changes when the price of good X changes. It is
evident from the movement of consumer from IC1 to IC2.

The income effect is the movement


from point C to point B.
B

A C
IC2

IC1

Quantity of X

Income effect

9
Quantity of Y

A C
IC2

IC1

Quantity of X
Substitution Income
effect effect

Price Effect 10
Case of Normal Goods
• If a good is normal, substitution and income
effects reinforce one another. It means :-
– when price falls, both effects lead to a rise in
quantity demanded [Ref. Previous slide]
– when price rises, both effects lead to a drop in
quantity demanded [Ref. next slide]

11
Quantity of y
An increase in the price of good x means that
the budget constraint gets steeper

Substitution effect : A C
C Income Effect : CB
A

B
IC1

IC2

Quantity of x
Substitution effect
Income effect
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Case of Inferior Goods
• In case of inferior Goods, substitution and
income effects move in opposite directions
• The combined effect is indeterminate
– when price rises, the substitution effect leads to a
drop in quantity demanded, but the income effect
is opposite
– when price falls, the substitution effect leads to a
rise in quantity demanded, but the income effect
is opposite

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THE SLUTSKY METHOD
Optimal bundle is A, on indifference curve
Y IC1.

IC1

xa
X
THE SLUTSKY METHOD
A fall in the price of X
Y The budget line pivots out from P

*
P

IC1

xa
X
THE SLUTSKY METHOD
The new optimum bundle is B on
Y indifference curve IC2.
The Total Price Effect is xa  xb

B
A IC2

IC1

xa xb
X
Price Effect
THE SLUTSKY METHOD
• Slutsky claimed that if, at the new prices,
– less income is needed to buy the original bundle
then “real income” has increased
– more income is needed to buy the original
bundle then “real income” has decreased
• To isolate the substitution effect, slutsky asked the
question : “What is the change in demand when
the consumer’s income is adjusted so that, at the
new prices, consumer can just afford to buy the
original bundle?”
THE SLUTSKY METHOD
• To isolate the substitution effect we adjust the
consumer’s money income so that s/he
change can just afford the original
consumption bundle i.e. we are holding
purchasing power constant.
Draw a line parallel to the new
Y budget line which passes through
the original optimal point A.

B
A IC2

IC1
xa xb
X
The new optimum bundle on IC3 is at C.
Movement from A  C is the substitution
X2 effect

B
A IC2
C

IC1 IC3
xa xc xb
X1
Substitution Effect
The remainder of the total price effect
is the Income Effect (CB).
Y

B
A IC2
C

IC3

xc xb
X
Income Effect
Case for NORMAL GOODS

• The substitution and income effects reinforce


each other when a normal good’s own price
changes.
THE SLUTSKY METHOD for NORMAL GOODS
The income and substitution effects
reinforce each other.

B
A IC2

C
IC3
xa xc xb
X