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

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