MICROECONOMICS

Income and Substitution Effects for a Normal Good



Income and Substitution Effects for a Normal Good

With the help of following diagram we are going to distinguish between the income and substitution effects for normal goods i.e. apples and oranges

The effect of a fall in price of apples: When the price of apples falls, the optimal bundle changes from A to C

The movement from A to B is a substitution effect relative prices change, real income does not. The movement from B to C is an income effect; (Frank 2002) real income changes, relative prices do not. A further price drop moves the optimal bundle to D. The line PEP, running from A to C to D, is the price expansion path.

A pure substitution effect always increases the consumption of good that has become relatively cheaper. You could see that via looking at the shape of indifference curve and imagining what happens as the budget line "rolls along it" (as it does from B1 to B' ). This corresponds to lowering the price of one good while at the same time cancelling out the gain to the buyer via either raising the price of other good or lowering income. On net, the buyer is neither better off nor worse off. The result is to increase the consumption of good that has become cheaper. (Frank 2002) The pure income effect from a decrease in price of a good (an increase in real income), on the other hand, might either increase or decrease its consumption, according to whether it is a normal or an inferior good.

A drop in price of one good without any compensating change in income or other prices produces both a substitution effect and an income effect, as shown on Figure; apples are cheaper than before relative to oranges, and the ...