Income and substitution effects of price change, Managerial Economics

Income and Substitution Effects of Price Change

When the price of a commodity falls the consumer's equilibrium changes.  The consumer can purchase the same quantity of X and Y as before the price change and still have some money to spare.  Such money is like an extra income but arises from the all of the price of one commodity.  The new purchasing power arising from the extra income is the income effect - and is the same as if income had increased without a change in prices and he would still have had to purchase more of each commodity shifting from budget line AB to DE. 

Due to the rise in purchasing power arising from a fall, in the price of one commodity, the consumer then decides how the increase in purchasing power is to be spread over X and Y.  The consumer reallocates expenditure to purchase relatively more of the cheaper commodity.  The substitution effect then arises from this decision implying change in the quantity of a commodity purchased due to the change in the relative prices.

The prices X and Y are £2 per unit respectively.  The consumer's income is £10. The consumer is in equilibrium at point P.  If the price of X falls from £2 to £1 per unit, the equilibrium point changes from P to P(1).  The movement from P to P(1) results from two forces.

First the fall in price implies rise in purchasing power as if income went up and prices remained constant.  At point P1 he derives more satisfaction than at point P.

At point P, he purchases three units of X, at point T he purchases four units of X and at P1 purchases six units.

The Income Effect in this example is one unit of X and the substitution effect is two units of X.  The price effect is the sum of income and substitution effects.

Posted Date: 11/27/2012 5:37:05 AM | Location : United States







Related Discussions:- Income and substitution effects of price change, Assignment Help, Ask Question on Income and substitution effects of price change, Get Answer, Expert's Help, Income and substitution effects of price change Discussions

Write discussion on Income and substitution effects of price change
Your posts are moderated
Related Questions
A firm supplied 3000 pens at the rate of Rs 10. Next month, due to a rise of in the price to 22 rs per pen the supply of the firm increases to 5000 pens. Find the elasticity of sup

Q. Explain the Short run production function? Discussion of production up to now has ignored the time required to build production facilities. There is a requirement to take in

Intended or planned Investment Expenditure on investment depends on business expectations on the chance of making profits and on the availability of funds for the purchase of p

What is Managerial economics according to Spencer and Siegelman Spencer and Siegelman:  Managerial economics is "the integration of economic theory with business practice for t

structure of managerial economics

An Economy consists of two regions, the North & the South. The short-run elasticity of labor demand in every region is -0.5. Labor supply is perfectly inelastic within both regions

Bank of Central Clearance ,Settlement and Transfer This function was first developed by the bank of England toward the middle of the nineteenth century. In 1954, a scheme was

State the relevant economic quantities Managerial economics helps the management in predicting numerous economic quantities like profit, cost, capital, demand, price, productio

Structural Unemployment The decline of the highly localized industry due to international trade causes great problems of regional (structural) unemployment.  If it would take

Model Specification   We proceed with the model specification in the following steps. 1)  The economy is composed of competitive firms (F  in number) and identical workers