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In obtaining Slutsky substitution effect, income of the consumer is adjusted to keep his purchasing power (i. e. real income) constant so that he could buy the original combination of goods if he so desires. On the other hand, in the Hicksian substitution effect, with a change in price of a good money income with the consumer is so adjusted that his satisfaction remains constant. Thus the analysis which is based upon the compensating variation is a resolution of the price change into two fundamental economic ‘directions’, we shall not encounter a more fundamental distinction upon any other route. But Slutsky method has a distinct advantage in that it is easier to find out the amount of income equal to the ‘cost difference’ by which income of the consumer is to be adjusted. On the other hand, it is not so easy to know the compensating variation in income.
But the ordinary demand curve may or may not slope downward. In the case of the ordinary demand curve like D, both the substitution and income effects are in operation and they explain the downward slope of the curve. When the price of Commodity-1 falls, keeping the real income and price of Commodity-2 constant, the budget line shifts to GH.
- As we know, a huge portion of income is spent on the consumption of inferior goods, the quantity demanded will be reduced from OY to OZ.
- Thus, in the case of normal goods, the positive income effect and negative substitution effect vary in the same direction, leads to an increase in the quantity demanded of apple juice.
- As explained above, the cost difference is equal to AP.Q where AP stands for the change in price of a good and Q stands for the quantity of commodity he was consuming prior to the change in price.
- It implies that the consumer is preferring the more inferior commodity-1 with a fall in price.
- It influences the consumer’s purchasing behavior by inducing him to buy more of the cheaper commodity.
- Hence, the direction of the movement of the substitution effect is certain i.e. negative.
But, there are also cases, where these both go in opposite directions. A fall in the relative price of one commodity leads to an increase in the consumption of that commodity. Thus, the substitution effect refers to the substitution of a cheaper commodity for the dearer one. It influences the consumer’s purchasing behavior by inducing him to buy more of the cheaper commodity.
His purchasing power changes by the amount equal to the change in the price multiplied by the number of units of the good which the individual used to buy at the old price. In other words, in Slutsk’s approach, income is reduced or increased , by the amount which leaves the consumer to be just able to purchase the same combination of goods, if he so desires, which he was having at the old price. In the above analysis of Slutsky equation, we have considered the substitution effect when with a change in price, the consumer is so compensated as to keep his real income or purchasing power constant.
In the case of Giffen goods, the consumers tend to buy more of a commodity with a rise in income. It implies, that the income and quantity demanded of Giffen goods are inversely related to each other. But the negative effect of substitution is less than the negative income effect because a consumer spends a huge https://1investing.in/ portion of his income on Giffen goods. And when the price of the commodity falls, a very large portion of income is affected. Thus, the negative effect of income generally outweighs the substitution effect. In the case of inferior goods, the consumers tend to buy less of a commodity with a rise in income.
Slutsky Compensated Demand Curve (With Diagram) Theorem and Derivation of Demand Curve
It may be pointed out here again that, unlike the Hicksian method, Slutsky substitution effect causes movement from a lower indifference curve to a higher one. While separately discussing substitution effect above, we pointed out the merits and demerits of the Hicksian and Slutskian methods of breaking up the price effect. As explained above, the cost difference is equal to AP.Q where AP stands for the change in price of a good and Q stands for the quantity of commodity he was consuming prior to the change in price. A perusal of the compensated demand curve D1of Hicks and D2of Slutsky shows that the curve D2is more elastic than D1.This is because the total expenditure on the purchase of good X is greater in the Slutsky approach than in the Hicks approach. While the conventional demand curves D3is more elastic than even the Slutsky demand curve D2.
It implies, that the income and quantity demanded of inferior goods are inversely related to each other. But the negative effect of substitution is more than the negative income effect because a consumer spends a small portion of his income on inferior goods. And when the price of the commodity falls, it affects a very little portion of income. Thus, the negative effect of income generally doesn’t outweigh the substitution effect. That is, the income is changed by the difference between the cost of the amount of good X purchased at the old price and the cost of purchasing the same quantity if X at the new price.
When the price of apple juice falls, assuming the real income and price of mango juice constant, the budget line shifts to GH. Here, the consumer will move from the equilibrium point D to the new equilibrium point E on the original indifference curve IC. It implies that the consumer is preferring the cheaper apple juice over the mango juice. Thus, in the case of normal goods, the positive income effect and negative substitution effect vary in the same direction, leads to an increase in the quantity demanded of apple juice. Here, the substitution effect increases the quantity from OX to OY whereas the income effect increases the quantity from OY to OZ.
Thus, the budget line and equilibrium point shifts to AC and point F on a higher indifference curve IC1.Point F depicts that the consumer is now purchasing more quantities than before. This movement of equilibrium points from E to F reflects the income effect. Since the fall in price increases income or purchasing power of the consumer which in case of normal goods leads to the increase in quantity demanded of the good, sign of the income affect has been taken to be positive. The price line GH is tangent to the indifference curve IC2at point S.
Price Effect – Combination of Substitution and Income Effect
Abhipedia , 360 degree exam Preparation platform is a product of 22 years of Experience of Abhimanu Expert Sh Parveen Bansal, caters to learning needs of students. Abhimanu , over the years since 1999 has become synonymous with commitment and innovation in various domains. There is another important version of substitution effect put forward by E. The treatment of the substitution effect in these two versions has a significant difference.
On the other hand, the compensated demand curves will have a negative slope because they are not affected by the income effect. As a result, the total effect from a fall in the price of the commodity-1 indicated from budget lines AB to AC, the quantity demanded of the inferior commodity increased by XZ. The movement of equilibrium point from D to F represents the increase in quantity demanded of commodity-1 from OX to OZ units.
This total fall in quantity XZ indicates the price effect. X is necessarily negative implying that fall in price will cause quantity demanded of the good to increase. Thus, in case of normal goods both the substitution effect and income effect work in the same direction and reinforce each other.
The price Effect shows the impact of both the income and substitution effect on the consumer equilibrium. The combination of both these effects is known as the Price Effect. Price Effect for Giffen GoodsIn fig, The X-axis shows the quantity of Giffen Commodity-1 and the Y-axis shows the quantity of Commodity-2. It refers to the change in the consumption of the commodities when the price of one of the commodity changes, provided the price of other commodities and income of consumers being the same. For this, a price line GH parallel to PL’ has been drawn which passes through the point Q. It means that income equal to PG in terms of Y or L’H in terms of X has been taken away from the consumer and as a result he can buy the combination Q, if he so desires, since Q also lies on the price line GH.
Thus, in the case of Giffen goods, the negative income effect and substitution effect varies in the opposite direction, leads to a reduction in the quantity demanded of the Giffen commodity-1. Here, the substitution effect and price effect is a combination of income effect varies in the opposite direction. When the price of an inferior commodity falls, the substitution effect leads to an increase in the quantity demanded whereas the income effect reduces the quantity demanded.
Price Effect – Combination of Substitution and Income Effect:
X) consumed becomes smaller and smaller, the income effect of the price change will becomes smaller and smaller. Thus, if the quantity consumed of a commodity is very small, then the income effect is not very significant. The above diagram shows the U indifference curve showing bundles of goods A and B. To the consumer, bundle A and B are the same as both of them give him the equal satisfaction. In other words, point A gives as much utility as point B to the individual.
As we know, a small portion of income is spent on the consumption of inferior goods, the quantity demanded will be reduced from OY to OZ. For normal goods, the consumer tends to buy more of a commodity with an increase in income. It implies that the income and quantity demanded are positively related to each other. Whereas the substitute effect and price are negatively related in this case.
What is the Price Effect?
Thus, in Slutsky substitution effect, income is reduced or increased not by compensating variation as in case of the Hicksian substitution effect but by the cost difference. When the price of Giffen commodity falls, the substitution effect leads to an increase in the quantity demanded whereas the income effect reduces the quantity demanded. The negative income effect outweighs the whole negative substitution effect. Therefore, the overall effect will be the decrease in the quantity demanded of that commodity due to a fall in the price. Actually, he will not now buy the combination Q since X has now become relatively cheaper and Y has become relatively dearer than before. The change in relative prices will induce the consumer to rearrange his purchases of X and Y.
What is ‘Indifference Curve’
Now, in order to find out the substitution effect his money income be reduced by such an amount that he can buy, if he so desires, the old combination Q. Price Effect for normal goodsIn fig, The X-axis shows the quantity of apple juice and the Y-axis shows the quantity of mango juice. AB is the original budget line and the consumer is in equilibrium at point D with indifference curve IC. X/∂I which shows the effect of a unit change in income on the quantity demanded of the good X.