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:
“Virtue is the adherence in action to the nature of things, and the nature of things makes it prevalent. It consists in a perpetual substitution of being for seeming, and with sublime propriety God is described as saying, I A—.”
—Ralph Waldo Emerson (1803–1882)
“But that intimacy of mutual embarrassment, in which each feels that the other is feeling something, having once existed, its effect is not to be done away with.”
—George Eliot [Mary Ann (or Marian)