Substitution Effect
The substitution effect is the effect observed with changes in relative price of goods. This effect basically affects the movement along the curve.
These curves can be used to predict the effect of changes to the budget constraint. The graphic below shows the effect of a price increase for good Y. If the price of Y increases, the budget constraint will pivot from BC2 to BC1. Notice that because the price of X does not change, the consumer can still buy the same amount of X if he or she chooses to buy only good X. On the other hand, if the consumer chooses to buy only good Y, he or she will be able to buy less of good Y because its price has increased.
To maximize the utility with the reduced budget constraint, BC1, the consumer will re-allocate consumption to reach the highest available indifference curve which BC1 is tangent to. As shown on the diagram below, that curve is I1, and therefore the amount of good Y bought will shift from Y2 to Y1, and the amount of good X bought to shift from X2 to X1. The opposite effect will occur if the price of Y decreases causing the shift from BC2 to BC3, and I2 to I3.
If these curves are plotted for many different prices of good Y, a demand curve for good Y can be constructed. The diagram below shows the demand curve for good Y as its price varies. Alternatively, if the price for good Y is fixed and the price for good X is varied, a demand curve for good X can be constructed.
Read more about this topic: Consumer Choice
Famous quotes containing the words substitution and/or effect:
“To play is nothing but the imitative substitution of a pleasurable, superfluous and voluntary action for a serious, necessary, imperative and difficult one. At the cradle of play as well as of artistic activity there stood leisure, tedium entailed by increased spiritual mobility, a horror vacui, the need of letting forms no longer imprisoned move freely, of filling empty time with sequences of notes, empty space with sequences of form.”
—Max J. Friedländer (1867–1958)
“The use of symbols has a certain power of emancipation and exhilaration for all men. We seem to be touched by a wand, which makes us dance and run about happily, like children. We are like persons who come out of a cave or cellar into the open air. This is the effect on us of tropes, fables, oracles, and all poetic forms. Poets are thus liberating gods.”
—Ralph Waldo Emerson (1803–1882)