Substitution Effect, Income Effect & Price Effect

Substitution Effect (S.E.) Definition: It refers to the change in quantity demanded for a good caused by a change in relative price, holding real income constant.

Substitution Effect (S.E.) Definition: It refers to the change in quantity demanded for a good caused by a change in relative price, holding real income constant. Qy Qx Px Qx Qx0 Qx1

Substitution Effect (S.E.) Definition: It refers to the change in quantity demanded for a good caused by a change in relative price, holding real income constant. Qy Qx Px Qx Qx1 Qx0

Substitution Effect (S.E.) Qx Px Qx Px

Income Effect (I.E.) Definition: It refers to the change in quantity demanded for a good caused by a change in real income, holding relative price constant.

Income Effect (I.E.) Definition: It refers to the change in quantity demanded for a good caused by a change in real income, holding relative price constant. Qy Qx I Qx Qx1 Qx0

Income Effect (I.E.) Definition: It refers to the change in quantity demanded for a good caused by a change in real income, holding relative price constant. Qy Qx I Qx Qx0 Qx1

Income Effect (I.E.) Qx I Qx I Normal Goods !!

Income Effect (I.E.) Qx I Qx I Normal Goods !!

Income Effect (I.E.) I Qx I Qx Normal Good Inferior Good Qy Qy Qx Qx Qy Qx Qx1 Qx1 Qx0 Qx0

Income Effect (I.E.) I Qx I Qx Normal Good Inferior Good Qy Qy Qx Qx Qy Qx Qx0 Qx0 Qx1 Qx1

Income Effect (I.E.) Qx I Normal Good: Inferior Good: Qx I Qx I I Qx

Price Effect (P.E.) Definition: It refers to the change in quantity demanded for a good caused by a change in relative price.

Price Effect (P.E.) Definition: It refers to the change in quantity demanded for a good caused by a change in relative price. Qy Qx Px Qx Qx0 Qx1

Price Effect (P.E.) Definition: It refers to the change in quantity demanded for a good caused by a change in relative price. Qy Qx Px Qx Qx1 Qx0

When price changes (P.E.) Relative price changes (S.E.) When price changes (P.E.) Real income changes (I.E.) P.E. = S.E. + I.E.

When price changes (P.E.) Relative price changes (S.E.) When price changes (P.E.) Real income changes (I.E.) P.E. = S.E. + I.E.

S.E. P.E. I.E. Px  Qx  Px  Qx  -ve I  Qx  I  Qx  normal gd +ve inferior gd -ve I  Qx  I  Qx 

Case 1 S.E. : Px  Qx  P.E. Assume Px  I.E. Qx  normal gd : +ve I  Qx  I.E. inferior gd : -ve I  Qx 

S.E. : Px  Qx  P.E. Px  I.E. Qx ? normal gd : +ve I  Qx  inferior gd : -ve I  Qx 

S.E. Case 2 S.E.  I.E. Case 3 I.E. S.E.  I.E. Px  Qx  Case 2 S.E.  I.E. Qx  Case 3 I.E. inferior gd I  Qx  S.E.  I.E. Qx 

Summary Case 1 -ve S.E. & +ve I.E. Case 2 -ve S.E.  -ve I.E. Px  normal gd -ve S.E. & +ve I.E. Qx  & Qx  Qx  Case 2 inferior gd non-giffen case -ve S.E.  -ve I.E. Qx   Qx  Qx  Px  Case 3 inferior gd giffen case -ve S.E.  -ve I.E. Qx   Qx  Qx 

Graphically Case 1 Normal good S.E. Qx  Qx  Px  Qx  I.E. -ve +ve Qy Qx S.E. -ve Qx  Qx  Px  Qx  I.E. +ve Qx0 Qx1 Qx0’

Graphically Case 1 Normal good S.E. Qx  Qx  Px  Qx  I.E. -ve +ve Qy Qx S.E. -ve Qx  Qx  Px  Qx  I.E. +ve Qx0 Qx1 Qx0’

Inferior good, non-giffen case Graphically Case 2 Inferior good, non-giffen case Qy Qx S.E. -ve Qx  Qx  S.E.I.E. Px  I.E. -ve Qx  Qx1 Qx0 Qx0’

Inferior good, non-giffen case Graphically Case 2 Inferior good, non-giffen case Qy Qx S.E. -ve Qx  Qx  S.E.I.E. Px  I.E. -ve Qx  Qx1 Qx0 Qx0’

Inferior good, giffen case Graphically Case 3 Inferior good, giffen case Qy Qx S.E. -ve Qx  Qx  S.E.I.E. Px  I.E. -ve Qx  Qx1 Qx0 Qx0’

Inferior good, giffen case Graphically Case 3 Inferior good, giffen case Qy Qx S.E. -ve Qx  Qx  S.E.I.E. Px  I.E. -ve Qx  Qx1 Qx0 Qx0’