Income And Substitution Effect Under Indifference Curve

In this revision video we look at the income and substitution effects for an inferior good.

Income and substitution effect under indifference curve. The movement from pt. A change from the blue indifference curve to the pink indifference curve. When the price falls the substitution effect is never perverse it will always cause more to be demanded. The decrease in quantity demanded due to increase in price of a product.

The income effect expresses the impact of higher purchasing power on consumption. A graph showing the substitution effect associated with a decrease in the price of good x. But in the case of an inferior product the income effect works in the opposite direction to the substitution effect. Suppose the price of x falls so that his new budget line is pq 1.

In terms of the graph the substitution effect is shown by rotating the original budget line around the initial indifference curve until it achieves its new slope. In this revision video we work through how to show the substitution and income effects arising from a fall in the market price of a product in our example w. The substitution effect is explained in figure 12 17 where the original budget line is pq with equilibrium at point r on the indifference curve i 1. Income effect arises because a price change changes a consumer s real income and substitution effect occurs when consumers opt for the product s substitutes.

Thus the movement form q to r due to price effect can be regarded as having been taken place into two steps first from q to s as a result of substitution effect and second from s to r as a result of income effect. The substitution effect describes how consumption is impacted by changing relative income and prices. The hicksian method is theoretically the correct one as with this method the substitution effect measures the effect of movement along an indifference curve due to change in relative prices whereas the income effect measures the effect of a movement between indifference curves at unchanged relative prices. X 2 involved a change in the marginal rate of substitution i e.

At r the consumer is buying ob of x and br of y. Income effect and substitution effect are the components of price effect i e. The substitution effect moves the consumer from the bundle labeled a to the bundle. A change in the slope of the indifference curve and a change in utility i e.