income effect and substitution effect power point

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

0 QxQx0 Qx1

Px

Qx

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

0 QxQx1

Qx

Px

Qx0

Substitution Effect (S.E.)

Px Qx

Px Qx

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

0 Qx

Qx

I

Qx0 Qx1

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

0 Qx

Qx

I

Qx1 Qx0

Income Effect (I.E.)

I Qx

I Qx

Normal Goods !!

Income Effect (I.E.)

I Qx

I Qx

Normal Goods !!

Income Effect (I.E.)

Normal GoodInferior Good

Qy

Qx0

Qx0 Qx1

QxIQy

Qx0

Qx0Qx1

QxI

Income Effect (I.E.)

Normal GoodInferior Good

Qy

Qx0

Qx1 Qx0

QxIQy

Qx0

Qx1Qx0

QxI

Income Effect (I.E.)

• Normal Good:

• Inferior Good: I

Qx

I

I

I

Qx

Qx

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

0 Qx

Px

Qx0 Qx1

Qx

Price Effect (P.E.)• Definition: It refers to the change in quantity demanded

for a good caused by a change in relative price.

Qy

0 Qx

Px

Qx1 Qx0

Qx

When price changes(P.E.)

P.E. = S.E. + I.E.

Relative price changes(S.E.)

Real income changes(I.E.)

When price changes(P.E.)

P.E. = S.E. + I.E.

Relative price changes(S.E.)

Real income changes(I.E.)

P.E.

S.E.

I.E.

Px ↓ Qx ↑Px ↑ Qx ↓

normal gd+ve

inferior gd-ve

I ↓ Qx ↓I ↑ Qx ↑

I ↓ Qx ↑I ↑ Qx ↓

-ve

P.E.Assume Px

↓

S.E. : Px ↓ Qx ↑

I.E.

normal gd :+ve

inferior gd :-ve

I ↑ Qx ↑

I ↑ Qx ↓

Qx ↑Case 1

P.E. Px ↓

S.E. : Px ↓ Qx ↑

I.E.

normal gd :+ve

inferior gd :-ve

I ↑ Qx ↑

I ↑ Qx ↓

Qx ?

S.E.Px ↓ Qx ↑

I.E.inferior gdI ↑ Qx ↓

S.E. I.E.

S.E. I.E.

Qx ↑

Qx ↓

Case 2

Case 3

-ve S.E. & +ve I.E.Qx ↑ & Qx ↑

Qx ↑

Qx ↓

Case 2inferior gd

non-giffen case

Case 3inferior gdgiffen case

Px ↓ -ve S.E. -ve I.E.Qx ↑ Qx ↓

-ve S.E. -ve I.E.Qx ↑ Qx ↓

Qx ↑

Case 1normal gd

Summary

Graphically

Px ↓

Qx ↑

Case 1 Normal good

Qy

0 QxQx0 Qx1Qx0’

S.E.-ve

I.E.+ve

Qx ↑

Qx ↑

Graphically

Px ↓

Qx ↑

Case 1 Normal good

Qy

0 QxQx0 Qx1Qx0’

S.E.-ve

I.E.+ve

Qx ↑

Qx ↑

Graphically

Px ↓

Qx ↑

Case 2 Inferior good, non-giffen case

Qy

0 QxQx0 Qx1 Qx0’

S.E.-ve

I.E.-ve

Qx ↓

S.E.I.E. Qx ↑

Graphically

Px ↓

Qx ↑

Case 2 Inferior good, non-giffen case

Qy

0 QxQx0 Qx1 Qx0’

S.E.-ve

I.E.-ve

Qx ↓

S.E.I.E. Qx ↑

Graphically

Px ↓

Qx ↑

Case 3 Inferior good, giffen case

Qy

0 QxQx0Qx1 Qx0’

S.E.-ve

I.E.-ve

Qx ↓

S.E.I.E. Qx ↓

Graphically

Px ↓

Qx ↑

Case 3 Inferior good, giffen case

Qy

0 QxQx0Qx1 Qx0’

S.E.-ve

I.E.-ve

Qx ↓

S.E.I.E. Qx ↓