Income Effect
Income Effect
The equilibrium of the consumer is obtained on the basis of the assumption that the income level of the consumer remains constant and prices of the two commodities also remain constant. When income of the consumer changes or when any price level changes the equilibrium position will be affected. When income increases, prices of the commodities remaining the same, the budget line shifts parallel to the right. This happens because there is a change in the intercept part of the equation of the budget line. If the budget line equation is: , an increase in Y, increases the intercept term which helps the budget line to shift parallel upwards.
We shall get a new budget line and a new point of tangency between the budget line and the indifference curve. The locus of successive points of tangency between parallel budget lines and the indifference curves is called the Income Consumption Curve (ICC). Thus the ICC shows the effect of change in come on the equilibrium amounts purchased of the two commodities. q2
ICC U2 U1 U0 M N q1
An ICC is generally upward rising if both the goods are normal. If (as given in the diagram above) q1 is inferior, the ICC can be backward bending. However, at the same point in time both goods cannot be inferior. Substitution Effect:
The substitution effect measures the effect of change in relative price of any commodity, the real income remaining the same. Hence, to explain substitution effect let us first explain what we mean by the terms ‘relative price’ and ‘real income remaining the same’. Relative price of any commodity is equal to the units of the other commodity that can be obtained in lieu of one unit of this commodity. It is the price of one commodity
The equilibrium of the consumer is obtained on the basis of the assumption that the income level of the consumer remains constant and prices of the two commodities also remain constant. When income of the consumer changes or when any price level changes the equilibrium position will be affected. When income increases, prices of the commodities remaining the same, the budget line shifts parallel to the right. This happens because there is a change in the intercept part of the equation of the budget line. If the budget line equation is: , an increase in Y, increases the intercept term which helps the budget line to shift parallel upwards.
We shall get a new budget line and a new point of tangency between the budget line and the indifference curve. The locus of successive points of tangency between parallel budget lines and the indifference curves is called the Income Consumption Curve (ICC). Thus the ICC shows the effect of change in come on the equilibrium amounts purchased of the two commodities. q2
ICC U2 U1 U0 M N q1
An ICC is generally upward rising if both the goods are normal. If (as given in the diagram above) q1 is inferior, the ICC can be backward bending. However, at the same point in time both goods cannot be inferior. Substitution Effect:
The substitution effect measures the effect of change in relative price of any commodity, the real income remaining the same. Hence, to explain substitution effect let us first explain what we mean by the terms ‘relative price’ and ‘real income remaining the same’. Relative price of any commodity is equal to the units of the other commodity that can be obtained in lieu of one unit of this commodity. It is the price of one commodity