Substitution Effect,Income Effect

&Price Effect

Substitution Effect (S.E.)• Definition: It refers to the change in quantity demanded f

or 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 f

or 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 f

or 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 f

or 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 f

or 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 f

or 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 Good

Inferior Good

Qy

Qx

0

Qx0 Qx1

QxI Qy

Qx

0

Qx0Qx1

QxI

Income Effect (I.E.) Normal Good

Inferior Good

Qy

Qx

0

Qx1 Qx0

QxI Qy

Qx

0

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 f

or a good caused by a change in relative price.

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

or 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 f

or 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