The Income and Substitution Effects

Topics: Consumer theory, Inferior good, Supply and demand Pages: 10 (1337 words) Published: October 13, 2014

The income and substitution effects of a change in the price of a good.

Economics and Information systems

Aboyowa Okoturo


The relationship that occurs between one’s consumption, his or her personal preferences and the demand curve is one of the most complex associations in economics. Unconditionally, an economist would carry the mind set that whatever is purchased by an individual is consumed, and the only exception to this is if the purchase is for a productive activity. With this essay, I intend to briefly examine the income and substitution effects that come from a change in the price of a good. The models defined below are just that: models – or basic illustrations of an evident fact (this time, a model of the way a consumer picks between two goods and what happens when the income and substitution effect go in opposite directions). This is a theoretical depiction; it captures the fundamental elements of consumer selection, predicting the way people will react to a change in price.

According to The Law of Demand, when there is a change in the price of a good, the amount of the good consumers are able and willing to pay for changes and figures go in the opposite direction. For example, when the price of event tickets go up, the quantity demanded for how many tickets one can purchase falls with all other things being equal (ceterus paribus). Preferences are the necessities by every individual for the consumption of goods and services, and they eventually translate into employment selections based on capabilities and the use of their income from employment for purchases of goods and services to be joined with the consumer's time to define consumption events. Consumption and production are two separate things, because there are two different consumers included. In the first instance, consumption is by the main individual whereas in the second instance, a producer might make a good that he would not consume himself. This means that different incentives and aptitudes are involved in the process. These models that make up the consumer theory are used to signify prospectively noticeable demand patterns for a single buyer on the premise of forced optimization. Protruding variables used to explain the rate at which the good is purchased or demanded are known as the price per unit of the good, prices of related goods, and the wealth of the consumer. The main theorem of demand states that the rate of consumption falls as the price of the good rises. This theory is called the ‘substitution effect’. The change in price of a good has two effects on a consumer. Firstly, the price of the good (let’s call this good p1) comparative to that of other products (assuming q2, q3, . . . qn) changes. Secondly, as a result of the change in p1, the consumer's real income changes. Real income is income measured at constant prices. The Substitution Effect is the effect of the relative price change alone, resulting in the change in real income, while the income effect is the change in consumption as a result of a change in an individual’s real income. When an individual’s income increases it causes the budget constraint to bow out in a parallel fashion. As shown in the diagram below, If both x and y increase as income rises, x and y are ‘normal’ goods.

As income increases, the individual decides to consume more x and y. If x decreases as income increases, x is an ‘inferior good’ as demonstrated in the diagram below. Y
When there is a change in price, there are two outcomes. These are the substitution effect and the income effect. To isolate the substitution effect, “real” income is kept constant but there is a change in the relative price of good x. The substitution effect is the movement from point A to point C The reason for an individual substituting good x for good y is because it turns out to be relatively cheaper. Though...
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