Substitution, Income and Price Effect

Written By Fathimath Sama on Saturday, 22 June 2013 | 14:01

The Substitution Effect 

The substitution effect takes place when the income of the consumer remains constant and the relative prices of the tow commodities changes. Suppose the price of one commodity rises and the other decreases now the consumer is neither better off nor worse off than before. However he will rearrange this purchase to compensate the loss. It means the consumer substitutes relatively cheaper goods for the relatively costlier ones. This can be shown in the following diagram. 

Let us assume the consumer purchases oranges and apples. Suppose if the price of the apple rises and the oranges decreases at this moment the consumer will purchase more oranges and less apples. 

In this diagram the consumer is in equilibrium at point Q because the price line AB touches the IC curve. Here the consumer purchases OM of oranges and ON of apples now the price of apples rises and the oranges decreases. Due to change in price consumer’s budget line will also change from AB to A1B1. At this level the consumer purchases OM1 of more oranges and ON1 of fewer apples. Now the consumer is in equilibrium at the point Q1 because the new budget line A1B1 touches the IC curve at this point. This is consumers new equilibrium point this is the substitution point. 

Income Effect:

The effect of changing consumer’s income on his satisfaction is known as the income effect. Here the consumer will be able to enjoy more or less satisfaction when his income increases or decrease assuming that the prices of the two commodities remain constant. Every increase in income takes him to higher indifference curve. He becomes better off than before. Every decrease in income on the contrary brings him down to the lower indifference curve. He becomes worse off than before. The income consumption curse traces the income effect. 

The income effect can be shown in the following diagram. 

Let us suppose that the consumer wants to purchase apples and oranges. At AB price line the consumer is in equilibrium at point T1 because IC! Curve intersects the price line AB. At this point the consumer purchases 5 oranges and 5 apples. If the income of the consumer increases the price line shifts upwards in the form of A1B1, A2B2, A#B# respectively. The increase in the income enables the consumer to consume more of both the commodities. The equilibrium point 3 will also move towards higher IC curve in the form of T1,T2,T3. If we join all these equilibrium points we obtain the curve known as income curve. The income doesn't trace the effect of a change in income of the consumer on the consumption of commodities. 

The Price Effect: 

The effect of a change in the price of a commodity on its purchase is known as the price effect. We shall now assume that the money income of the consumer remains constant and the prices of orange falls and apples remain unchanged or constant. Now the consumer purchases more oranges. The fall in the price of oranges actually increases the real income of the consumer though his money income remains constant. The cheapness of the oranges induces the consumer into purchasing more and the price line shifts towards right. 

This price effect can be show in the following diagram. 

In this diagram the consumer is in equilibrium at point Q where the IC curve is tangent to AB price line. At this level the consumer purchases 10 oranges and 10 apples. Now the income of the consumer and the price of oranges fall. Now the consumer wants to purchase more of oranges his price line will rotate anti clock wise in the form of AB1. Suppose if the price of orange is still falling the price line will shift towards right in the form of AB2 and the consumer equilibrium point will also changes from Q to Q1. Here the consumer will go on purchasing more and more oranges. There we get new equilibrium points such as Q,Q1,Q2 etc. If we join al these points we get a curve known price consumption curve (PCC). 

Suppose if there is any rise in prices of orange the consumer purchases less of oranges and the price line will be clockwise. 

The price consumption curve shows only various combination of oranges and apples that give maximum satisfaction to the consumer.

Notes provided by Prof. Sujatha Devi B (St. Philomina's College)
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