Price Effect As Sum of Substitution and Income Effects
Further information: Slutsky equation and Hicksian demandEvery price change can be decomposed into an income effect and a substitution effect; the price effect is the sum of substitution and income effects.
The substitution effect is a price change that alters the slope of the budget constraint but leaves the consumer on the same indifference curve. In other words, it illustrates the consumer's new consumption basket after the price change while being compensated as to allow the consumer to be as happy as he or she was previously. By this effect, the consumer is posited to substitute toward the good that becomes comparatively less expensive. In the illustration below this corresponds to an imaginary budget constraint denoted SC being tangent to the indifference curve I1.
If the good in question is a normal good, then the income effect from the rise in purchasing power from a price fall reinforces the substitution effect. If the good is an inferior good, then the income effect will offset in some degree the substitution effect. If the income effect for an inferior good is sufficiently strong, the consumer will buy less of the good when it becomes less expensive, a Giffen good (commonly believed to be a rarity).
In the figure, the substitution effect, is the change in the amount demanded for when the price of good falls from to (increasing purchasing power for ) and, at the same time, the money income falls from to to keep the consumer at the same level of utility on :
The substitution effect increases the amount demanded of good from to . In the example, the income effect of the price fall in partly offsets the substitution effect as the amount demanded of goes from to . Thus, the price effect is the algebraic sum of the substitution effect and the income effect.
Read more about this topic: Consumer Theory
Famous quotes containing the words price, effect, sum, substitution, income and/or effects:
“Thou blind man’s mark, thou fool’s self-chosen snare,
Fond Fancy’s scum and dregs of scattered thought,
Band of all evils, cradle of causeless care,
Thou web of will whose end is never wrought;
Desire! desire, I have too dearly bought
With price of mangled mind thy worthless ware;”
—Sir Philip Sidney (1554–1586)
“To see distinctly the machinery—the wheels and pinions—of any work of Art is, unquestionably, of itself, a pleasure, but one which we are able to enjoy only just in proportion as we do not enjoy the legitimate effect designed by the artist.”
—Edgar Allan Poe (1809–1849)
“The real risks for any artist are taken ... in pushing the work to the limits of what is possible, in the attempt to increase the sum of what it is possible to think. Books become good when they go to this edge and risk falling over it—when they endanger the artist by reason of what he has, or has not, artistically dared.”
—Salman Rushdie (b. 1947)
“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 secret of success lies never in the amount of money, but in the relation of income to outgo.”
—Ralph Waldo Emerson (1803–1882)
“Each of us, even the lowliest and most insignificant among us, was uprooted from his innermost existence by the almost constant volcanic upheavals visited upon our European soil and, as one of countless human beings, I can’t claim any special place for myself except that, as an Austrian, a Jew, writer, humanist and pacifist, I have always been precisely in those places where the effects of the thrusts were most violent.”
—Stefan Zweig (18811942)