Answer to Question #274667 in Microeconomics for Rishabh

Question

Explain the price effect, income effect and substitution effect of a price change for a normal

commodity using suitable diagram.

Answer 1

The overall effect of an increase in the price of good X is a decrease in its consumption from OX1 to OX2 (X2X1). The substitution effect is the difference between OX1 and OX3 (X3X1), the income effect is the difference between OX3 and OX2 (X2X3). The substitution effect is determined by the movement along the same indifference curve, and the income effect is determined by the transition from one curve to another. The income effect enhances the effect of the substitution effect, increasing consumption of good X when its price decreases,

and reducing consumption when prices increase.

The substitution effect is a change in demand (consumption) caused by a change in relative prices. When the price of a product, for example, falls, other products become relatively more expensive. The consumer then has an incentive to increase the consumption of the given good at the expense of others.

The overall effect of a price change is the sum of two effects:

Overall effect = Substitution effect + income effect.